May 16, 2018
This article is intended to provide an overview of the current legal landscape for taxation of cryptocurrencies and other blockchain tokens in the United States. This article is for informational purposes only, and does not constitute legal, tax, or accounting advice. Please consult with an appropriate professional to obtain advice specific to your situation.
Bitcoin is the first and most popular cryptocurrency, and the one that has become a household name. While there is still speculation as to what actually drives the value of Bitcoin, Ethereum, Ripple, and other cryptocurrencies, they all have (or strive to have) the essential properties of any fiat currency: the are fungible, store value, and can be used as payment in transactions.
Unlike a fiat currency, cryptocurrencies are not backed by a government or central bank. Instead, cryptocurrencies are creatures of one or more blockchains. Each blockchain is an immutable, append-only, distributed ledger, recording each cryptocurrency transaction to ensure that coins cannot be double-spent.
Thousands of additional coins and tokens have appeared since the creation of Bitcoin, each with its own properties and marketplace. Some of these strive to be a coin, not tied to a particular application, organization or company. Others are purportedly tokens for the use with a specific application, framework, API, etc. The term token has typically been used in an attempt to avoid securities regulation – creators argue that they have a "utility token" which is used for a specific purpose, and thus not a "security" subject to the additional regulatory requirements intended to protect consumers and investors. A close look at most of these "utility" tokens reveals that they contain more of the characteristics of a security or investment than of a software license, for example. The speculative nature and wild value fluctuations for many tokens indicate that they are being treated, by their creators and purchasers, as investments. A true utility token should not have a wildly speculative value. If users had to purchase a utility token to use Microsoft Office, and one day the value was $10, the next it was $100 and the following it was $3, the token would not be of much use to consumers or software developers.
What Makes a Cryptocurrency or Token Taxable?
The IRS issued guidance in IRS Notice 2014-21 on March 25, 2014, as to the taxation of virtual currencies, including cryptocurrencies and related blockchain tokens. Specifically, the IRS specified that a virtual currency: (a) is not legal tender in any jurisdiction, and therefore is not treated as a US or foreign currency for tax purposes; and (b) is convertible into a fiat currency at some valuation.
For federal tax purposes, virtual currencies are treated as "property" (as defined in IRC §1211(a)) putting them in the same class as other capital assets such as precious metals, stocks, bonds, and real estate. Taxpayers that accept virtual currency as payment have to treat that as payment in US dollars, valued at the time of the receipt. The same valuation becomes the payee’s initial basis. If the virtual currency is listed on an exchange, with an exchange rate determined by market supply and demand, then the valuation is established from the exchange.
Similarly, upon the sale of a virtual currency, the taxpayer has to report a capital gain or loss. That gain or loss will be based upon the initial basis, which coins or tokens were sold, and the holding period, as described in more detail below.
Capital Gains and Losses
The federal tax code taxes capital gains and losses differently than ordinary income. In order to determine the tax on the disposition of a capital asset, the taxpayer generally needs to know the basis and the holding period.
The basis of a capital asset tracks the amount of value for which taxes have already been paid. Under IRC §1012, a taxpayer purchasing 1 ETH for $600 would have a $600 basis in that 1 ETH. Under IRC §1001, upon the sale of that 1 ETH, the taxable gain or loss is measured from the basis, so a sale for $500 would generate a $100 capital loss, and a sale for $750 would generate a $150 capital gain. If the taxpayer gifts the 1 ETH to another individual, the recipient typically has a carry-over basis under IRC §1015, meaning that the recipient will get the same $600 basis as the original owner.
The holding period for a capital asset tracks how long the taxpayer has owned the capital asset. If the holding period is not more than one year before a disposition, then the taxpayer has a short-term capital gain (or loss) under IRC §1222. If the holding period is more than on year, then the taxpayer has a long-term capital gain (or loss) under IRC §1222. Long-term capital gains are taxed at a lower, preferential rate than income and short-term capital gains. If a taxpayer gifts the 1 ETH in our example above to another taxpayer, the recipient typically has a "tacked" holding period, meaning that their holding period starts from when the first taxpayer purchased.
Rarely do transactions involve the sale of exactly the same amount of coins as were purchased. A taxpayer may have purchased cryptocurrency over several transactions, and then may sell partial coins over several other transactions. When a taxable sale or exchange occurs, how do you determine which coins were sold?
The federal tax code permits several different cost basis allocation methods:
- First-in-first-out (FIFO). The oldest assets are sold first. This is the most common method, and helps to ensure sales of assets with the longest holding period (thus most likely to get a better tax treatment) are sold first. In a world of appreciating currencies, this is often the ideal method.
- Last-in-first-out (LIFO). The newest assets are sold first. This may reduce the amount of gain recognized initially, as the newest coins, presumably with the highest basis, are sold first, resulting in less capital gain recognition at the outset.
- Average Cost Basis (ACB). The total holdings receive an average cost. The holding period is determined on a first-in-first-out (FIFO) basis.
- Highest-in-First-out (HIFO). The assets with the highest cost are sold first, ignoring the holding period. Like LIFO, this can reduce the initial capital gains recognition, but could possibly cause sales of assets that have a longer holding period.
Special Capital Gains Situations
In addition to the gift examples cited above, there are a few other sections of the federal tax code that can modify capital gains tax treatment.
IRC §1031 Like-Kind Exchange
IRC §1031 allows for a like-kind exchange of one asset to another, whereby the basis and holding period are transferred form the first asset into the second, deferring the tax recognition event. This is commonly done in real estate, where the taxpayer sells one investment property and buys another one but defers the tax. For tax years ending on or before December 31, 2017, some taxpayers took the stance that an exchange of one cryptocurrency to another could be treated as a like-kind exchange. This argument required a further analysis of the IRC §1031 requirements and what truly was a "like-kind" cryptocurrency.
Consequently, many taxpayers have chosen not to characterize their exchanges as deferred under IRC §1031.
The Tax Cuts and Jobs Act of 2017 modified IRC §1031 to limit its applicable only to real estate transactions. Therefore, for tax years starting on January 1, 2018 or later, the like-kind exchange option is clearly unavailable to virtual currencies.
IRC §1014 Step-Up on Death
IRC §1014 allows for a reset in the capital gains basis for any assets transferred upon the death of a US taxpayer. While the estate may be subject to an estate tax (currently for US citizens and residents, the first $11.18 Million is not taxable on the federal level at death), the capital assets themselves get a step-up in basis. In our example of 1 ETH for $600, if the taxpayer died at a time when ETH was worth $800, the taxpayer’s heirs would receive the 1 ETH with a $800 basis, and would only have capital gains (or losses) from that point forward.
Contributions to Partnerships and Corporations
In some cases, appreciated capital assets can be contributed to a partnership (including an LLC taxed as a partnership), or to a corporation (including an LLC taxed as an S or C Corporation), and the basis can be carried over to the partnership or corporation.
IRC §351(a) allows for capital assets to be traded for stock in a corporation (or entity taxed as a corporation) if the persons contributing assets for stock are in control of the corporation (as defined in IRC §368(c)) immediately after the exchange. This could allow a group of people to start a corporation, contribute appreciated cryptocurrency, and defer the capital gains recognition event. This exception does not apply to investment companies, as defined in IRC §351(e)(1).
Likewise, IRC §723 allows for capital assets to be traded for a partnership interest in a partnership (or a membership interest in a multiple-member LLC that is taxed as a partnership), with the partnership receiving a carry over basis. In the partnership context, the control immediately after the transfer is not required, giving more flexibility as to when this could occur, but investment companies are still excluded. This could be used, for example, by an investor contributing cryptocurrency to a startup business in exchange for some membership interest, and would be most effective in the context where the startup intended to use the cryptocurrency as part of its operations (e.g. use ETH to run smart contracts on the Ethereum blockchain).
IRC §1091 contains special rules for wash sales of stock or securities. A crypto coin or token that is treated as a security may be subject to the wash sale rules, which state that if a stock or security is sold at a loss and then re-acquired within thirty days, the loss is not deductible. For example, a taxpayer buys 1 TOKEN for $900 on February 1st, and then sells it for $600 on March 1st, generating a $300 short-term capital loss. The then repurchases that 1 TOKEN on March 15th for $500, and then sells it again on April 12th for $1,000, generating a $500 short-term capital gain. Because the 1 TOKEN was repurchased within 30 days of the loss sale, the loss is not deductible, resulting in a $500 short-term capital gain, even though the taxpayer only made a total of $200 between the two transactions.
In the case of a hard fork of a blockchain (such as the Bitcoin (BTC) hard fork to create Bitcoin Cash (BCH)), typically the taxpayer would not have a taxable event upon the fork, but their basis in the new cryptocurrency created by the fork would be zero.
Moving Between Wallets
Transferring cryptocurrency between one wallet and another is not a taxable event, but the costs of making the transfer (mining / GAS fees) may be deductible as an investment expense.
Converting Cryptocurrencies or Buying Tokens
A sale of one cryptocurrency (e.g. BTC) for another (e.g. ETH) would be a taxable event. A capital gain or loss would be determined by the sale of the one cryptocurrency, and then the full fair market value of the new currency would be the taxpayer’s basis in the newly purchased cryptocurrency. The holding period would also reset, with a new holding period starting for the new currency.
Selling a Cryptocurrency for a Fiat Currency
Likewise, the sale of a cryptocurrency in exchange for a fiat currency would create a taxable capital gains event. Every time you use 0.003 BTC to buy a pizza, you could have a separate taxable event.
Mining a cryptocurrency is treated similar to other business operations. The inputs to mining (electricity, mining hardware, internet connectivity) are all business expenses, some of which may need to be depreciated if they are not deductible under IRC §162 or IRC §179. When a mined coin is received, the miner has an income tax recognition event, and from that point forward holds a capital asset. For example, a miner spends $400 on hardware, electricity and internet costs to mine 1 ETH, which is valued at $750 on the day the miner receives it. The miner reports $750 in income, less $400 in expenses, for a $350 taxable profit. The miner then owns 1 ETH with a basis of $750, and with the holding period beginning upon the date the coin is received.
With mining pools, a miner may receive many transfers of fractions of a coin, each of which would have its own basis and holding period to track.
Tools for Tracking Cryptocurrency and Token Tax Liability
Since even a small amount of cryptocurrency or token holding can quickly result in many small transactions, most taxpayers will need software to help track their tax liability. Several offerings are already available:
Taxation of cryptocurrencies can be complex. While a stock brokerage firm will often track tax ramifications for their customers, the decentralized nature of blockchain puts the onus for tax tracking on the individual user. The IRS has already begun issuing subpoenas to large cryptocurrency exchanges to get records of their users, as the IRS speculates that only a small portion of cryptocurrency sales from the past few years have been properly reported. Close adherence to the tax rules are crucial, and individuals needing advice should seek out the expertise of a CPA or tax attorney qualified to advise them on the proper reporting of their cryptocurrency transactions.