What are cryptocurrencies?
Cryptocurrency, unlike traditional currency, are decentralized, digital units stored in a virtual wallet that have a specific value that fluctuates based on the market. Most virtual currencies have an equivalent value in traditional currency and therefore can be used in the same way as traditional currencies. The most common cryptocurrencies are Bitcoin (BTC), Ethereum (ETH) and LiteCoin (LTC), however, there are more than 2000 different currencies with more being created constantly.
How are they created?
The majority of virtual currencies are acquired by a process called “mining”. This is a process where computers solve complex mathematical problems, verify transactions and group them in “blockchains”. Blockchains are the underlying platform for the large majority of cryptocurrencies. The way it works is the following: when Person A pays Person B a certain amount with a cryptocurrency that transaction is routed thru a third-party which verifies the authenticity, amount and accuracy of the transaction. Virtual currencies can also be saved in a virtual wallet and traded on third-party exchanges similar to traditional currency exchanges. Exchange prices are determined by supply and demand and the trading platforms are virtual so anyone can participate in trading, although some trading platforms have restrictions. Trading platforms like Coinbase and Gemini are in the United States. Virtual currencies just as traditional currencies can be used to purchase products and can be lent to others and earn interest.
How are they taxed?
When it comes to taxation, virtual currencies are treated as property by the IRS and are governed by the same principles as a property transaction. Taxation is based on the type of transaction (Payer, Payee, Miner, etc.). An employer can pay its employees with virtual currencies and it should be included in the employees W-2 wages, which are subject to FICA and FUTA taxes just like regular wages. The amount paid should be listed as the Fair Market Value of the virtual currency at the time of disbursement to the employee. Employees paid in virtual currencies must ensure their employers reports the wages paid in cryptocurrencies in their W-2s.
Independent contractors
If as an independent contractor you receive payment in cryptocurrency, you must include the Fair Market Value of the currency at the date received in your gross income. Gross Income in excess of $600 in Fair Market Value must be reported in a Form 1099-MISC. Due to the fact that compared to the US Dollar virtual currency value is highly volatile, accurate records of transactions must be kept. There are multiple sites that provide historical values of virtual currencies on specific dates. Average value on the date of the transactions can be used to measure Fair Market Value. You should be aware that you must report income in the form of virtual currencies even if you do not receive a Form 1099.
Mining operations
Miners must also report income in the form of Fair Market Value. Although there is no set determination to whether mining is passive or active income each individual situation can be determined by following rules in Sec. 469. Miners who engage in mining as a trade or business are subject to self-employment tax. They can also deduct expenses like equipment, utilities, and rent. Miners who generate income from the sale of virtual currencies are not subject to capital gains tax as new units of cryptocurrency are classified as inventory.
Notice 2014-21 states that trading virtual currency is similar to trading stocks. In turn, this means that short-term gains will be taxed as ordinary income and short-term losses will upset ordinary income up to $3000.
Trading cryptocurrencies with other cryptocurrencies
Further complications ensue when trading cryptocurrencies with other cryptocurrencies. When this happens the gains/losses must be reported in US Dollars. This means you could owe taxes but have no traditional currency to pay it with. Be aware that most exchanges do not provide a Form 1099, therefore accurate records of transactions are very important. As with regular currency, virtual currency can be lent. It is important for taxpayers to record interest received and that interest must be reported on your tax return. A virtual wallet is considered a foreign account for reporting purposes. Therefore the IRS requires compliance with FBAR and FATCA. It is also best to report virtual wallets held overseas.
Always remember to follow all the tax laws and regulations. If you are not familiar with the process of taxation of cryptocurrencies, please contact a professional. We here at The Tax Firm believe that cryptocurrency is the future and have spent countless hours researching all aspects of it, don’t hesitate to contact us.