One of the newest frontiers for both individual and institutional investors is the cryptocurrency market. Exemplified by the rapidly growing Bitcoin (BTC), these “currencies” (more on that, later) are intangible digital assets that are designed to provide a secure and anonymous medium of wealth exchange that is fully decentralized from any sort of governmental authority or central banks. While initial interest centered on BTC, hundreds of alternative coins (“altcoins”) have debuted and grown rapidly through 2017.
Growth
Bitcoin is not a new phenomenon, with the first peer-to-peer software for coins released back in 2009. It initially gained appeal among niche online communities, such as gamblers and dark web criminals, who needed a reliable and encrypted method of transferring their illicit wealth. As more and more systems of computers joined the complex and overhead-intensive process of “mining” new Bitcoins into existence, the broader online community began to take notice of BTC as a legitimate medium of exchange. According to the International Business Times, as of February 2015, over 100,000 different merchants accepted BTC worldwide.By December 31, 2016, the price for one Bitcoin had ballooned from an initial trading point of $0.06 at its August 2010 debut to nearly $1,000. Between January 1, 2017 and November 27, 2017, the value of a single coin has peaked at over $9,500, creating mainstream media attention and fueling investor curiosity.
Taxation
The IRS first formally addressed cryptocurrency treatment in 2014, with Notice 2014-21. While cautioning about the uncertain and dynamic nature of virtual currency regulation, the release did clarify a few core concepts:
- Wages, independent contractor payments, and self-employment income paid in virtual currencies are all subject to applicable regulations, as if the transaction occurred in dollars
- Character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer
- Information reporting requirements for payments made in property apply to cryptocurrencies
Additionally, the notice indicated that these assets are not formally currencies for gain reporting purposes, but rather a form of commodity that can be an ordinary or capital asset based on the taxpayer’s activity. This distinction exempts taxpayers from potential foreign currency transaction reporting requirements that would otherwise apply. For most taxpayers that are not in the trade or business of investment management, any sales will be capital in nature. Cost basis rules apply just as they would for purchased or inherited securities.
Regulation since 2014 has been murky. A September 2016 release by the Treasury Inspector General for Tax Administration (TIGTA) acknowledged that tax reporting and compliance enforcement efforts relating to virtual currencies have been slow to develop. Perhaps in response to this report, the IRS filed an application to serve a John Doe summons on Coinbase Inc., one of the largest cryptocurrency storage and exchange platforms in the world. Similar tactics have been employed over the past decade to root out undisclosed foreign bank accounts as part of a revamped FBAR system. While the scope of their request was reduced in July 2017 to only users with transactions of at least $20,000, Coinbase is still actively fighting such a precedent that could destroy the asset’s reputation for anonymity. The outcome of this ongoing dispute could directly determine how cryptocurrencies are regulated in the future.
Outlook
Moving forward, tax preparers need to exercise caution when it comes to virtual currencies. The meteoric rise of Bitcoin, Ethereum, and other large-capitalization coins has brought in billions of dollars to the market, and the lack of formalized reporting may tempt some individuals to under-report gains. It is incumbent on the tax preparer to establish acquisition date and costs with transaction records from the client’s cryptocurrency digital wallet, and then determine the basis associated with each sale. Wallets, such as the one offered by Coinbase, clearly reflect time-stamped transactions for the full trading history of their owners. Until the Treasury Department has determined a more effective means of regulating cryptocurrency traders and tracking sales activity, such source data will provide the best information for tax professionals.
As cryptocurrency becomes more common, prospective and current investors should consider the tax treatment of these currency types. Give us a call if you have questions.
Greg Ward, CPA, joined Dalby, Wendland & Co.’s Glenwood Springs office in August of 2013. He attended the University of Illinois at Urbana-Champaign and attained a bachelor’s degree in accounting, with highest honors. Greg works in the areas of individual taxation, estates and trusts, small business taxation, tax-exempt organization reporting, and foreign reporting. He is a member of the American Institute of CPAs, Colorado Society of CPAs, National Eagle Scout Association, and volunteers his time as the treasurer for the Colorado Society of Certified Public Accountants Roaring Fork Chapter.
