By Paul Staples, Tax Manager | Financial Services Industry Team
New compliance requirements on taxpayers’ virtual currency investments
For the first time in five years, the IRS has issued additional guidance related to virtual currency investments. Since the original IRS guidance came out in 2014, there have been some outstanding compliance questions that the IRS aims to answer. The new guidance comes as IRS auditors have started to take a closer look at cryptocurrency investments during audits of individual returns.
What is cryptocurrency?
At a high level, cryptocurrency is a virtual currency that uses cryptography to secure transactions, control units, and handle the transfer of assets. Bitcoin and other currencies are controlled through distributed ledger technology (blockchain) that serves as a transaction database. While it may appear and act as “real” currency in some environments, it is important to note that it does not have legal tender status in the United States.
Since it is not legal tender, the IRS has classified virtual currency as property and typically applies those same principles to the taxation of virtual currency. Under those rules, sales of virtual currency are considered short or long term capital gains depending on whether or not it was held for more than one year (assuming it is classified as investment income and not received for services). Virtual currency exchanged for other property, including for other cryptocurrencies, is considered a taxable event. Virtual currency received in exchange for property (other than purchasing for cash) is also considered a taxable transaction.
Though not discussed here, it should be noted that virtual currency received in exchange for services is typically considered ordinary income to the taxpayer. The fair market value at the time the currency is received would be considered income as well as your basis in the digital asset.
Under the guidance issued this month, the IRS also clarifies that a taxable transaction occurs when a coin splits as part of a “hard fork” and the new coins are distributed through an “air drop.” A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change that results in a permanent diversion from the existing currency or ledger. Solely the creation of a new cryptocurrency or ledger is not necessarily a taxable event. However, if an air drop – a distribution of cryptocurrency to the taxpayer – of the new currency occurs as part of the hard fork, the new coins would be considered income equal to their fair market value.
With the increased scrutiny and complex reporting, it is important for taxpayers to understand the compliance requirements of their virtual currency investments. The IRS released a draft of the 2019 1040 Schedule 1 recently that will require taxpayers filing Schedule 1 to answer whether or not they had any virtual currency transactions during 2019. In addition, the IRS has also issued notices to taxpayers advising them that prior year transactions are subject to taxation and amended returns may be necessary if gains and losses were not properly reported.
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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.