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Preparing your own tax returns is hard enough when you are a regular employee with standard deductions. But what about when some of your currency only exists digitally? What do you need to know about reporting cryptocurrency on your tax returns? Will your accountant even know what to do before the IRS releases its new guidance?
Before diving too deeply into the tax implications of digital currency, it is worth taking a moment to briefly describe how cryptocurrency works and whether it is, in fact, money. In 2008, an inventor named Satoshi Nakamoto invented a software program that allowed users to track large numbers of transactions securely through an open source database accessible to all its users. The program, called Blockchain (which uses the cryptocurrency Bitcoin), creates a decentralized ledger which is date-stamped and pushed to every user of the program simultaneously. The program essentially serves the same purpose as a bank or even the U.S. Treasury, except that the system to authenticate transactions is spread out across its millions of users.
Cryptocurrency users can buy, sell, and transfer the virtual Bitcoins in their wallets with other users within the same program. They can also earn new cryptocurrencies by spending time “mining” the database and confirming the transactions. The number of Bitcoins or other currencies remains the same until the user does something to change it. However, the value of cryptocurrency can fluctuate wildly compared to the U.S. dollar depending on everything from the popularity of the particular cryptocurrency to the performance of the Stock Market.
So when your Bitcoins suddenly triple in value, have you received income? What if you make a purchase using digital currency? What are your responsibilities in reporting cryptocurrency on your tax returns?
The IRS requires U.S. taxpayers to report all income on their annual tax returns. This includes everything from wages to interest earned on bank accounts and investments. That gets difficult when the assets involved aren’t measured in dollars. The IRS requires most taxpayers to report their income in U.S. dollars, even if it is actually received in a foreign currency. To do so, taxpayers and their accountants must apply the appropriate exchange rate as of the time the foreign payment was received or value accrued. This calculation can sometimes be difficult and time consuming, and is why anyone receiving foreign income is advised to speak to an accountant familiar with international tax issues.
That complexity becomes even more challenging when cryptocurrencies are involved, for several reasons. First, the value of cryptocurrencies can vary drastically one day to the next. For example, on the day this article was written, a bitcoin’s value had dropped $213 dollars in just the last 24 hours, and had increased by $60 in just 10 minutes.
There are also business strategies that the owners of cryptocurrency companies use to build the industry which can make it even more difficult to determine the monetary value of a person’s wallet. For example a “hard fork” splits one coin into two, transitioning holders from one index to another as technology evolves. There is a legal question about whether both the new and old coins count, and how they should be valued, since the user has no choice but to receive the new cryptocurrency.
In addition, many cryptocurrency companies employ promotional techniques called “airdrops” where they deposit tiny amounts of currency into the accounts of their users, essentially raining virtual money down on those users. While the value of these airdrops are unlikely to significantly affect a person’s taxable income, when paired with the market volatility discussed above, they could push someone’s assets into a different taxable bracket without their knowing it.
Regulation always lags behind technology in any industry, and the regulations around reporting cryptocurrency on your tax returns are no different. The IRS first published guidelines for “convertible virtual currencies” reporting in 2014, directing that they should be treated like property. But that hasn’t proven very helpful.
When determining the value of property received as income, a taxpayer needs to track the value of each unit of the asset. So if you received 200 collectible baseball cards, you would need to track the change in value of those cards from the time you acquired them until you sold them for money. That change is considered taxable income and must be reported on your tax returns. While there is software out there to do this kind of one-for-one asset tracking, it can be difficult to know which of the bitcoins in your wallet you used to make a transaction, and by extension, how much income you received for it.
As the number of cryptocurrency users continues to increase, the IRS has received pressure from all sides, including Congress and the American Institute of Certified Public Accountants, to provide meaningful guidance for reporting cryptocurrencies. It recently announced that it would be revising its guidance “soon”, which tax attorneys hope means the new rules will be done before it comes time to file next year’s tax returns.
When currency isn’t tied to a bank, country, or treasury, it becomes difficult to measure its worth. That makes reporting cryptocurrency on your tax returns extraordinarily difficult. The promised IRS guidance could help, but until then, bitcoin miners are encouraged to keep meticulous records of their transactions. Be sure to work with accountants and tax attorneys who understand the market, and the technology, so you can be sure your tax returns are filed properly once the guidelines are released.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding reporting cryptocurrencies on your tax returns, contact Joe Viola to schedule a consultation.