Tax implications for the crypto-citizen in the United States

As we draw closer to tax filing deadlines, more and more members of the crypto-community are concerned about how their tax returns must be prepared.

According to Credit Karma, only 0.04% of tax returns filed to the Inland Revenue Service (IRS) reported cryptocurrency transactions in 2017. As part of a series of crackdowns, the IRS has previously issued summons to Coinbase to turn over the names and information of over 14,000 account holders with $20K or more in their Coinbase accounts. Moreover, the IRS has passed new tax reforms and assigned personnel to track down and hold responsible, those guilty of tax evasion.

The IRS hasn’t been proactive about communicating guidance on taxation for cryptocurrencies and the last real guidance on the matter was issued in 2014. Concern is rampant that the IRS not issue new guidance in March this year as it will make matters even more complicated for those trying to meet already burdensome requirements, in a legal fashion.

Whilst it is strongly recommended that all crypto-citizens report their earnings and file their taxes, there is also a great desire to shelter these earnings from the government’s hands. And to this effect, research has been done on return-filing options that could reduce the taxes due, for example, IRC Section 1031 on like-kind exchanges.

However, this method presents its own risks in that it is not widely used and could result in the IRS rejecting tax returns filed this way. A request for new returns could also leave the tax filer vulnerable to penalties, fees and other issues, not to mention now being on the IRS’s radar.

What creates greater risk for the crypto-citizen filing taxes is that the exchanges have not been very responsible or standardized in maintaining records of deals. Some exchanges will simply deduct transaction fees from gains to reflect a net gain and others will share fees with the user.

Some exchanges have tried to mitigate the negative effects of this but not as effectively as the crypto-citizen would have hoped for. For instance, Coinbase has now created a report that attempts to reflect the net gain/loss made by the user in the selected reporting period, however, it does so using the market price of the digital currency as at the date of the report – inaccurate and overstated at best, the user has no real idea what can and cannot be tax deductible from their capital gains. This creates a great degree of error in an already onerous reporting challenge.

Understanding the various taxable events and potential applications when filing a tax return:

It is most important to note that virtual currencies are far more fungible than stocks and securities and therefore, the number of taxable events in crypto-transactions greatly exceeds those concerned with the latter.

  1. You are holding cryptocurrencies:
    If you are holding your virtual currencies, there is no tax on the appreciation of your holdings. If you decide to move your holdings from one exchange to another it is not classified a taxable event either. In simple terms, the flow of cryptocurrencies from one wallet address to another wallet address is not taxable.
  2. Purchase of cryptocurrencies using fiat currencies:
    If cryptocurrencies are purchased using fiat currencies, it does not qualify as a taxable event. If, however, alt coins are purchased using bitcoin (which had to have been exchanged for cash to buy the alt coins), that transaction is taxable.
  3. Internal Revenue Code, Section 1031, Like-kind exchanges:
    Does cryptocurrency qualify as like kind property? Like-kind represents a new asset class and requires an in-depth analysis to determine whether something is, indeed, like-kind. For that matter, cryptocurrencies can merely be analogized against other like-kind properties.Whilst it is possible for cryptocurrency to be like-kind and it’s certainly not illegal yet, the IRS could disagree and reject the use of like-kind in a tax return. And if it was to be rejected, the taxpayer would have to fight it, go to higher court or pay it plus interest and penalties. In addition, a tax bill was recently amended to restrict like-kind transactions only to real estate.
  4. Hardforked coins:
    It is recommended that hardforked coins are treated as a capital asset with a cost basis of zero as the user had full access to the coin at the time of the fork and no cost was incurred at the time of acquisition. Any appreciation on the new coin is also considered capital gains.
  5. Airdropped and mined coins:
    Airdropped and mined coins are considered ordinary income and can be filed as normal income taxes would be filed.
  6. Initial Coin Offering (ICO):
    If the ICO is considered a security and was not registered with the SEC, ramifications await the issuers of the ICO. However, should this be a utility token (and classified as a product or a service) taxation is treated normally as an income tax return.
  7. Gifting of cryptocurrency:
    Gift taxation rules apply here and all crypto-citizens can enjoy a tax-free gift limit of $14K per person/year, which does not need to be reported. If you do go above your gift limit, you will need to file a gift tax return which is $11MM if you’re single and $22MM if you’re married.
  8. Lost or stolen cryptocurrency:
    Loss or deduction amounts are based on what was paid for the coin. New tax regulations did not honour casualty losses and so there is not much to protect those with lost or stolen cryptocurrency. Capital loss, however, is different from theft or casualty loss. One could have a case for capital loss on an exchange failure but it needs more thorough investigation.

For a look at complete guidance, refer to this PDF produced by the IRS.

Image from Shutterstock.

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