Public fascination with cryptocurrency tends to follow dramatic gains and losses in the market. While the latter results in pundits sounding the death knell for Bitcoin and its ilk, the most reliable predictor for the lifespan and legitimacy of crypto lies in the Internal Revenue Service—and some newly minted crypto-holding clients may have questions about the virtual currency checkbox on their tax year 2020 Form 1040.
Eagle eyed do-it-yourself filers will have noticed that checkbox moved from the 2019 Schedule 1 to directly above the standard deduction question on the 2020 Form 1040. Those who have been quietly holding onto cryptocurrency as a hedge against inflation—or hoping to become an overnight millionaire—may have felt a jolt of panic after realizing Uncle Sam is keeping tabs. Heck, you might have even received a few phone calls that earned you a new client.
For a better understanding of crypto tax liability, we’re going to walk through a few common questions.
What is cryptocurrency?
Cryptocurrency is virtual currency that is backed by an encryption algorithm designed to prevent coin-duplication counterfeiting. The current supply of any given coin is generated by “crypto mining:” Think the gold standard, but instead of a precious metal, crypto-miners use their computer—or warehouses full of them—to solve a complicated math problem in order to mine (create) a set number of coins that they can sell.
In addition to serving as a fiat currency alternative, some virtual currencies offer additional functionality, like “smart contracts” and Internet access. The value promised by projects like Ethereum and other Bitcoin alternatives has given rise to a wide “altcoin” market that is available to investors on a number of cryptocurrency exchanges.
Note: The terms “cryptocurrency,” “crypto,” and “virtual currency” will be used interchangeably throughout the rest of this blog.
How does the new virtual currency question on the Form 1040 affect cryptocurrency holders?
The inclusion of a yes-no virtual currency question that reads “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” seems self-explanatory. But to cover our bases, we spoke with Drake Software Federal Tax Product Manager Robin Miles, EA.
“We know that IRS is beginning to pay a lot of attention to the trading and use of virtual currencies, because they now require every taxpayer to affirm or deny their participation in the market,” Robin said. “At this time, it is just a ‘Yes’ or No’ question that must be answered on the main input screen.”
However, answering this question isn’t necessarily as straightforward as it may seem at first. According to Q5 in the 46-question virtual currency FAQ on IRS.gov, taxpayers do not have to answer “yes” if they only bought virtual currency with “real currency” (USD) last year. So, when do taxpayers need to answer “yes?” Seemingly, only when there is a cryptocurrency exchange with tax-related consequences.
When do taxpayers need to pay tax on their cryptocurrency?
The IRS treats cryptocurrency as property, so taxpayers generally need to report income in these situations:
- The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or following a hard fork
- An exchange of virtual currency for goods or services
- A sale of virtual currency
- An exchange of virtual currency for other property, including for another virtual currency (“Virtual Currency,” DrakeSoftware.com)
Now, let’s take a closer look at two items from that list: hard forks, and virtual currency sales.
Hard Fork: The software that any given cryptocurrency is based upon is not set in stone. Sometimes an update can be so significant that it results in the creation of a new, separate cryptocurrency that exists alongside the original. This is called a hard fork, and it can result in a taxpayer suddenly having this new crypto deposited in their account by what is often referred to as an “airdrop.” (Fun fact: Bitcoin Cash was created by a hard fork in Bitcoin.)
After being given the new cryptocurrency, recipients will owe income tax for the year they acquire it: “When you receive cryptocurrency from an airdrop following a hard fork, you will have ordinary income equal to the fair market value of the new cryptocurrency when it is received, which is when the transaction is recorded on the distributed ledger, provided you have dominion and control over the cryptocurrency so that you can transfer, sell, exchange, or otherwise dispose of the cryptocurrency” (Q23).
Important: If a taxpayer is not given any new cryptocurrency following a hard fork, they do not owe income tax (Q22).
Sale of Virtual Currency: Generally, investors buy and sell virtual currency on exchanges, like Binance.us and Coinbase. The purchase of cryptocurrency for the purpose of investment does not result in owing income tax, but selling virtual currency—whether for USD or another crypto—can be considered a taxable. The amount of tax owed is generally determined by how much it was worth at the time of purchase (the basis), its fair market value at the time of the sale, and how long it was held (short-term versus long-term capital gain).
If a taxpayer sells crypto for more than they paid to acquire it on the exchange, that’s a capital gain. Just like stocks, crypto that is held for less than a year is subject to short-term capital gain tax; crypto sold after a year is subject to long-term capital gain tax. The trick—especially for newer investors—can be record keeping.
US-based cryptocurrency exchanges report to the IRS, so users should receive relevant forms from their exchange to help determine tax owed, like Forms 1099-B, 1099-K, and 1099-INT. That said, it would be wise for investors to separately keep track of all information related to the purchase and sale of crypto, just in case they don’t receive one of these forms.
To learn more about specific cryptocurrency tax issues, be sure to check out the IRS FAQ in the link below.
Source: “Frequently Asked Questions on Virtual Currency Transactions,” IRS.gov
MEA Tax Advisors