Every day seems to feel more and more feel like we are living in Orbit City, the imaginary, high-tech world portrayed in the 1960s American sitcom The Jetsons. Self-driving cars already exist, and we have robots that vacuum our homes for us. It’s only a matter of time until we see flying cars, after all, it’s 2022 and The Jetsons was set in 2062.
As we move towards a futuristic society, it is important we begin to understand the implications of virtual currency, which the IRS defines as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” When virtual currency can establish that it has an equivalent value in real currency, it becomes “convertible.
Today, there are more than 4,000 virtual currencies, including Bitcoin (BTC), Etherium (ETH), Tether (USDT) and Dogecoin (DOGE). They are stored and traded on more than 8,600 cryptocurrency exchanges around the world, including Kraken and the largest exchange, Coinbase, which became a public company in 2021. As virtual currency becomes a more prevalent part of society, understanding how using this form of currency impacts your tax bill is crucial, especially because it is not always treated the same as paper currency.
For U.S. income-tax purposes, virtual currency can be treated as a capital asset or property. This means there is a potential tax event when it is sold and exchanged for other types of property, used as payments for goods and services or held as an investment. In the last several years, the IRS has started to increase enforcement in this area.
Here’s a quick primer on the income-tax basics associated with transactions of virtual currency held as capital assets.
The IRS Form 1040, Individual’s Federal Income Tax Return, (in draft for as of the time of this writing) asks the question “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?” In general, the answer to this question should be “yes” if you had any transactions involving virtual currency. However, if your only transaction involved purchasing virtual currency with real currency, you should answer no.
How is a gain or loss calculated when virtual currency is sold for real currency, i.e. cash?
The gain or loss on the sale of virtual currency is the difference between your adjusted tax basis in the virtual currency and the exchange price you received in return. Generally, your adjusted basis is the initial purchase price, including fees, commissions, and certain acquisition costs. If the holding period was longer than one year, you may be eligible to receive the preferential tax rate applied to long-term capital gains.
If virtual currency is received as payment in connection with a service provided how should that be taxed?
When you receive virtual currency in exchange for performing services, it generally is treated as taxable ordinary income for which you should report the fair market value as measured in U.S. dollars as of the date of receipt. Virtual currency may also be considered self-employment income subject to self-employment tax.
If virtual currency is used to pay for services, what is the tax implication?
Virtual currency held as a capital asset and used to pay for services results in the recognition of a capital gain or loss based on that exchange. You can calculate that gain (or loss) as the difference between the fair market value of the services you received and your adjusted basis in the virtual currency exchanged.
What happens when virtual currency is exchanged for other property, including goods?
Generally, you would have a taxable gain or loss for the difference between the fair market value of the property you received and your adjusted basis in the virtual currency exchanged. If this transaction happened at an arm’s length, your basis in the property received is the fair market value at the time of the exchange.
The rules surrounding virtual currency can be complex. As its use increases in the future, we can expect the IRS to issue additional rules and reporting requirements. For now, however, the best advice is for individuals owning virtual currency to maintain appropriate documentation and records supporting positions they take on their individual income tax returns. This includes keeping receipts for sales and exchanges and proof of your tax basis, as well as engaging knowledgeable tax advisors to ensure proper reporting.
Sarah Gaymon is an Associate Director of Tax Services at Berkowitz Pollack Brant Advisors + CPAs in their West Palm Beach office. She helps high-net-worth individuals create sophisticated trust and estate structures that enable them to plan for wealth transfer and advantageous tax status. A frequent speaker and author, she has written dozens of articles about estate planning and wealth preservation and presented at numerous conferences and trainings.