When it comes to a return on an investment, very few have provided a greater return in 2019 than the cryptocurrency Bitcoin. This highly volatile, digital asset has seen its price skyrocket, increasing 200% over the last several months. With these types of returns, many investors are strongly enticed to invest over fear of missing out, but investors may not realize and understand the tax treatment behind these investments.
What is cryptocurrency?
Cryptocurrency is a digital asset that uses encryption techniques [cryptograph] to secure and verify transactions. While most typical currencies are issued by a central bank, cryptocurrency is decentralized through the use of blockchain technology. As a result, cryptocurrency cuts out the need for banks to facilitate transactions by using a peer-to-peer system to securely and freely exchange the digital asset.
Although Bitcoin is considered the preeminent cryptocurrency, there are many other alternative cryptocurrencies, each with different purposes or specifications. An alternative cryptocurrency that has been trending is Facebook’s recently announced “Libra,” which is backed by some major corporations and may rival Bitcoin once it hits the market.
IRS treatment – investors
The IRS has established that cryptocurrency is treated as property and is, therefore, subject to the same general tax principles that apply to property. Consequently, investors in cryptocurrency will typically receive capital gain treatment.
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Example 1: On Jan. 1, 2019, G purchases one bitcoin for $10,000. On May 31, 2019, G sells the same bitcoin for $12,000. G has a short-term capital gain of $2,000, which is taxed at ordinary income tax rates. If G held the bitcoin for longer than one year, then the gain would be taxed at favorable capital gain tax rates.
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Example 2: On Jan. 1, 2019, G purchases one bitcoin for $10,000. On July 31, 2020, when the value of the bitcoin is $15,000, G exchanges the one bitcoin for 100 ethereum [a separate cryptocurrency] at a price of $150 per ethereum. This exchange will trigger a recognized gain of $5,000, even though G never received any cash.
Some taxpayers may look to alleviate a portion or all of the recognized gain through IRC Sec. 1031 treatment [like kind exchange]. However, investors should be aware that the recently passed [federal tax reform] eliminated IRC Sec. 1031 treatment for all property except real property.
Cryptocurrency is typically transferred on one of the various cryptocurrency exchanges. Unfortunately, none of these exchanges issues monthly statements or year-end 1099’s to report the transactions that occurred during the year. Therefore, it is up to each taxpayer to keep track of these transactions during the year.
Typically, cryptocurrency is stored either on an exchange or a virtual wallet. Taxpayers need to understand where these digital assets are stored as this may require the taxpayer to file an FBAR [Report of Foreign Bank and Financial Accounts] or a Form 8938 [State of Specified Foreign Financial Assets] depending on the value of the assets.
Finally, determining the fair market value for these digital assets can be challenging. Separate exchanges may value a cryptocurrency differently. Proper valuation is needed not only for recognized gain transactions and potential foreign compliance requirements but also if investors want to take advantage of a popular trend to donate cryptocurrency to a valid 501(c)(3) charitable organization.
Ron Dean is director of tax services at Restivo Monacelli, a tax, accounting and business-advisory firm with offices in Providence and Boca Raton, Fla.
