Cryptocurrency has a Special Role in Income Taxes
Cryptocurrencies have been around for longer than you think, and we’ve only heard from the Internal Revenue Service (IRS) twice – in 2014 and 2019 – on how they think crypto should impact your tax burden.
From the beginning, the IRS has designated virtual currency as property. Because of this identification, cryptocurrencies are subject to capital gains taxes.
What is Crypto or Virtual Currency?
The most popular cryptocurrencies are house-hold names by now – Bitcoin, Ethereum – but there are thousands out there that you haven’t heard of.
All crypto or virtual currency is a digital representation of value that works outside of national currencies. But just like currency, crypto can be used to exchange value in terms of transactions.
While being marked as “property,” crypto has some of the same properties and characteristics of stocks and are subject to rising and falling values like any investment.
One reason people are pursuing cryptocurrencies is because it is secure. Transactions are encrypted with specialized computer coding and put into a blockchain. A blockchain is essentially a public ledger that lives in the digital world.
How do Cryptocurrency and Long-Term Capital Gains Work?
At the onset of cryptocurrency popular, the IRS made sure to put out an initial notice to secure their piece of digital currency income.
That ruling – IRS Notice 2014-21 – stated that the IRS considers cryptocurrency to be property. As property, it is subject to capital gains taxes that are reported on Schedule D and Form 8949 if necessary.
If you hold your cryptocurrency for more than a year, any profits are considered long-term capital gains and are subjected to those tax rates. If you owned your crypto for a year or less before spending or selling, profits are classified as short-term capital gains that are taxed at your ordinary income rate.
If you are worried about how you’ll be taxed, our team of tax strategists can help. There are also tables available online for the current year’s short-term and long-term capital gains tax rates.
The 2019 Revenue Ruling and What It Means
In 2019, the IRS released their first updated guidance on cryptocurrency in five years. Many questions needed answering on how to handle some of the interactions of virtual currency. To understand the 2019 guidance, we’ll need to explain two actions first.
The easiest way to think of a hard fork is when you receive a new credit card if your old one is thought to be compromised. In crypto, the currency on one of those distributed public ledgers undergoes a change that results in a permanent move away from the initial ledger. Sometimes this creates a new cryptocurrency.
The most famous hard fork occurred in 2016 when the Ethereum blockchain included a crowd-sourced venture capital fund called The Distributed Autonomous Organization (DAO). An error in the blockchain code of the DAO enabled someone to steal $45 million in cryptocurrency from the DAO. DAO leadership used a hard fork to create a new cryptocurrency. This made the old cryptocurrency worthless and deprived the digital robber of that $45 million.
Each cryptocurrency holder has a digital wallet. An airdrop occurs when virtual currency is distributed to the wallet address, typically for free. The goal of an airdrop is to create awareness and broad distribution for a blockchain project. It can also be used in hard forks, distributing new cryptocurrency to the holders of the old cryptocurrency.
The 2019 Revenue Ruling provided FAQs with some answers, but also raised more questions about the future of cryptocurrency and taxes. Here’s some of the things that are explained:
- If a hard fork happens and you receive the same fair market value of new cryptocurrency that you had in the old cryptocurrency, no gross income is recognized.
- If you get airdropped a new cryptocurrency, then you have an accession of wealth and you must recognize that new cryptocurrency as gross income of that date.
- If you transfer virtual currency from a digital wallet or account belonging to you to another wallet that is yours, this is a non-taxable event.
- If you receive virtual currency in exchange for providing services, you recognize ordinary income. Your basis in the virtual currency is the fair market value when the currency is received.
- If you receive cryptocurrency as a gift, no income is recognized until you sell, exchange, or somehow get rid of the currency. Your basis in the virtual currency gift differs depending on whether you will have a gain or loss when you sell or get rid of the holding.
Some Advice from The Richest Doctor
In David Auer’s book, The Richest Doctor: A Modern Parable of Financial Independence, there’s a ton of information about understanding risk and investing smarter. It’s important to learn and know what type of investor you are – the “Too Busy to Learn” investor, the “Accredited Investor Level,” or one of our higher levels. Although the book is for physicians, there is great advice for all high-income professionals.
If you are prepared to learn the ins and outs of cryptocurrency, the better chances you have of investing and understanding the ramifications of gains on your tax picture. We recommend reading up, finding a mentor that is already successful in cryptocurrency investing, and also reading The Richest Doctor to understand how investing and cryptocurrencies might play a part in your financial independence.
There are a lot of nuances to cryptocurrencies. There’s much more to crypto than we could cover in this article. Good luck with any moves you make in this space, and don’t hesitate to reach out to the Provident CPAs team with tax questions!