Since the inception of cryptocurrency in 2009, the very concept of currency has been challenged and debated. This article explains briefly what cryptocurrency is, how it works, and the current federal income tax implications on transactions using cryptocurrency.

What is cryptocurrency and how it works

Cryptocurrency is virtual currency. The virtual part comes from the encryption-based transaction-recording ledger system called blockchain. Blockchain is a peer-to-peer platform housing the open ledger. Decentralization is the key feature of the blockchain technology. In a blockchain open ledger, there is no central custodian, no central server, and at the same time the open ledger is able to maintain the transaction integrity and the anonymous status of the users. To ensure the integrity of the transactions, a group of engineers (or coin miners) connect blocks, or bundles of transactions, by random guessing within a mathematical decryption algorithm (secure hash algorithm, or SHA-256). Any currency used by the users in these recorded transactions via blockchain is considered cryptocurrency, like the first and most popular “bitcoin.” Due to the open source and simple architecture of the blockchain, developers can create other cryptocurrencies or extensions of the blockchain that perform more than the open ledger maintenance. To date, there are over a thousand different cryptocurrencies.

The technology was first introduced after the financial crisis in 2008 by an unidentified person who uses the name Satoshi Nakamoto. The blockchain technology is an escape from governmental monetary programs. The engineers who developed these virtual transaction networks embedded the idea of a free currency: free from quantitative easing and free from the intentional devaluation by central banks. This is the reason that cryptocurrencies are very popular in certain developing countries such as Venezuela. Blockchain’s peer-to-peer network cannot be shut down and there is no party that controls the entire system. An analogy of the blockchain’s open ledger is the games and tokens (the cryptocurrency) at an arcade (the blockchain). First, all players follow a fixed set of rules. Second, the total number of tokens circulating are designed to increase by a small amount as the number of transactions increases. And third, any tokens won or lost are displayed on the scoreboard along with player aliases for all to see. As a result, the scores cannot be changed and the token balances (win/loss) are mapped to anonymous aliases.

The first cryptocurrency, bitcoin, did not receive much popularity until a few years ago, when illegal online marketplaces, such as the Silk Road, became available. Given their anonymous nature, cryptocurrencies are commonly used in illegal transactions. The Silk Road was shut down in 2017, but cryptocurrencies such as bitcoin have persisted and are even more popular. Now, it is an accepted payment method for many merchandises. Several regular consumptions such as rent, car payments, or real estate could be made in bitcoins. In 2018, the state of Ohio became the first state to accept cryptocurrency for tax payments.

The rising popularity comes with the rising demand; and, as a result, more and more investors hold bitcoin solely for price speculation. The extreme price volatility of bitcoin from 2016 to 2019 caused some investors million-dollar profits and some million-dollar losses. Bitcoin investors have seen price increases from $433.50 at the end of 2016 to $19,163 on December 10, 2017 alongside similar decreases. At the end of 2018, bitcoin was traded at $3,796; and five months later, it was traded at more than $8,000. Some investors believe this popularity will only accelerate the adoption of cryptocurrency payments, which can lead to continual price growth in the years to come.

IRS Notice 2014-21

According to Alex Lielacher of Bitcoin Market Journal, in 2019, around two-thirds of bitcoin owners are inactive users while one third of bitcoin owners are active currency users. Despite their similarity to a government-issued currency, cryptocurrencies are not considered currencies for federal income tax purposes according to IRS Notice 2014-21. Below, I provide a brief overview of IRS Notice 2014-21 and a 2017 U.S. District Court decision regarding a cryptocurrency exchange—Coinbase.

Cryptocurrency trading

According to IRS Notice 2014-21, cryptocurrencies are treated as properties rather than foreign currencies. Therefore, for most taxpayers, cryptocurrencies are considered capital assets and the trading gains/losses are capital gains/losses. This has benefits toward long-term cryptocurrency investors. Currently, there are several exchanges that issue cryptocurrencies (such as Coinbase or Gemini) and taxpayers or practitioners can refer to the listed prices on those exchanges to determine the taxable income/loss. However, since there is no centralized exchange, the listed prices of cryptocurrencies are slightly different among the exchanges. For taxpayers who do not use a public cryptocurrency exchange, there seems to be some discretions in choosing the transaction prices among the exchanges.

Moreover, since cryptocurrencies are treated as properties, the common belief is that they are not subject to the IRC Sec. 1091 wash sale rule. The IRS has been silent on such exemptions. Given the extreme volatility of cryptocurrency prices, it is not unlikely that the IRS will someday propose to add cryptocurrencies alongside the securities that are subject to the wash sale rules.

Cryptocurrency payments

The real complication of taxation on crypto-transactions happens when a taxpayer uses a cryptocurrency to make payments. Since a cryptocurrency is treated as a property, if a taxpayer uses cryptocurrency to purchase merchandise, the taxpayer may incur capital gains/losses. According to IRS Notice 2019-21, the merchant that accepts cryptocurrency payment has a gross receipt in the amount of the number of cryptocurrency received times the listed price of the cryptocurrency on the date of the receipt. For a taxpayer who uses a cryptocurrency to pay for a merchandise or service, the taxpayer has a capital gain (loss) if the fair market value of the merchandise or service is higher (lower) than the tax basis of the cryptocurrency paid. Suppose a taxpayer has one bitcoin with a tax basis of $3,000, and uses 0.5 bitcoin (including the cryptocurrency transaction fee) to purchase a $2,000 laptop when the bitcoin is traded at $4,000. Then the taxpayer has a capital gain of $500 ($2,000-$3,000*0.5). Note that the high volatility of the cryptocurrency prices, it is expected that taxpayers who are active cryptocurrency users will need a capable bookkeeping system to determine total gain/loss. Several cryptocurrency tax service providers have emerged to help taxpayers sort out the gains/loss of crypto-transactions over the past few years.

When cryptocurrency is used by an employer as compensation payments, the employer is subject to reporting requirements and has to provide a W-2 or 1099-MISC to the employee. The employee has salary or wage income based on the price of the cryptocurrency on the date of the receipt.

Reporting obligations of cryptocurrency exchanges

According to the U.S. District Court decision letter in 2017 (Practitioner vs Coinbase), the IRS argued that fewer than 1,000 taxpayers reported taxable income or loss from cryptocurrency transactions each year between 2013 and 2015. In 2014, the IRS issued Notice 2014-21 which provides that cryptocurrency exchanges are third-party settlement organizations, and are required to file and provide a 1099-K when a user has more than 200 transactions and the user has total gross transaction amount exceeding $20,000. Therefore, for a vendor that accepts cryptocurrency as a payment method and uses an exchange such as Coinbase to clear the payments, the exchange is required to report the monthly transaction amounts to the IRS when the number of transactions and total transaction amounts exceed the above-mentioned thresholds. Conversely, if a taxpayer makes fewer than 200 transactions or has a total transaction amount less than $20,000, the cryptocurrency exchange is not required to report the transactions.

In 2016, the IRS summoned Coinbase, the largest cryptocurrency exchange in the U.S., to provide detailed user identification data, including copies of drivers’ licenses, passports, and even the public key to the crypto wallets, of users who have annual transaction amounts over $20,000. The District Court ruled that Coinbase is required to provide a user’s taxpayer ID number, name, address, and date of birth; but it also ruled that the IRS cannot summon the copies of the users’ driver’s licenses, passports, or public keys. Despite this partial win, there is still a great amount of difficulty for the IRS to enforce collections in cryptocurrency transactions. In 2013, the federal government officially announced that cryptocurrency exchanges are money services businesses and are subject to the reporting guidelines under the Banking Secrecy Act (FinCEN 2013). Nonetheless, when a taxpayer uses cryptocurrency exchanges that are not established in the U.S., there is no direct guidance on whether these foreign exchanges are subject to the reporting requirements under the Foreign Accounts and Tax Compliance Act (FATCA). Furthermore, if a taxpayer does not use any exchange at all, but operates purely using an electronic wallet, the IRS may not be able to detect incompliance if the taxpayer omits cryptocurrency transactions in the federal income tax return. It is still reasonable to assume that cryptocurrencies create opportunities for tax evasion and increase the difficulty of enforcement for government revenue agencies.

Cryptocurrency mining

As discussed above, miners are the engineers that add the transaction records to the blockchain. The blockchain program will automatically reward the miners with cryptocurrency to incentivize more miners to join the network and help maintain an open ledger. IRS Notice 2014-21 provides that miners should report gross income based on the value of the cryptocurrency rewarded on the date of receipt. More importantly, if a miner engages in crypto-mining in a capacity other than as an employee, the related mining income is subject to the self-employment tax. As a self-employed taxpayer, the miner is also able to consider the related costs and expenses related to the mining process. Based on the interpretation of IRS Notice 2014-21, it appears that a taxpayer may claim to mine cryptocurrency as a hobby to avoid the self-employment tax based on facts and circumstances. However, when a taxpayer claims an activity as a hobby, the taxpayer faces the risk of not being able to deduct part of the costs, expenses, or losses from the hobby.

Cryptocurrency lost in computer hacks

Since cryptocurrencies are digital, they are subject to computer hacks. It is reported that global cryptocurrency theft amounts to more than a billion dollars in 2018. For federal income tax purpose, the loss from cryptocurrency theft is deductible only when the taxpayer considers the cryptocurrency activities as trade or business, or production of income activities. Theft loss from personal-use properties are not deductible unless it is caused by a federally declared disaster. To be able to deduct the theft loss, the taxpayer needs to provide related proof of loss and the tax basis of the lost cryptocurrencies.

Conclusion

While more and more taxpayers participate in cryptocurrency transactions, the majority of the participants seem to be traders who speculate on the price fluctuation rather than active users who use cryptocurrency in exchange for goods or services. IRS Notice 2014-21 treats cryptocurrency as a property rather than foreign currency. Such treatment causes the trading gains/losses of cryptocurrencies to be capital gains/losses. The treatment also creates complex bookkeeping requirements for venders and consumers that use cryptocurrencies in the transactions. Due to the decentralized nature of the blockchain technology, when a taxpayer does not use a U.S. cryptocurrency exchange, it will be difficult for U.S. revenue agencies to investigate the crypto-transactions. With the IRS’s partial win in Practitioner vs. Coinbase in 2017, it is expected that the IRS will provide more guidance on the reporting responsibility on other participants going forward.