Curtailing Tax Surprises with Cryptocurrency

As investing in Bitcoin, Dogecoin and other cryptocurrencies becomes increasingly popular, investors need to understand the potential tax ramifications. Unlike traditional currency, the IRS views cryptocurrency as property for federal income tax purposes and even asks about it on IRS Form 1040. By classifying it as property, gains and losses are reported as capital transactions on Schedule D.

Many transactions involving cryptocurrency — such as purchases of goods or services — become taxable events. The purchase price paid with the currency is the value reported as proceeds on Schedule D. In addition, certain changes to the blockchain (the distributed digital “ledger” on which cryptocurrency transactions are typically recorded) can trigger taxable income.

Gains and losses-more information on reporting

Because cryptocurrency is property, investors recognize a capital gain or loss when they sell it in exchange for traditional currency. As with other capital assets, the amount of gain or loss is the difference between the adjusted basis in the cryptocurrency (usually, the amount paid to acquire it) and the amount for which it’s sold. And, as with other capital assets, gain or loss may be short term or long term, depending on whether an investor held the cryptocurrency for more than one year. If cryptocurrency is sold at a loss, there may be limitations on the deductibility of the capital losses.

Cryptocurrency owners often are surprised to discover using cryptocurrency to pay for goods or services can also trigger a capital gain or loss. Let’s say you purchased 10 units of cryptocurrency 10 years ago for $1,000 each, or a total of $10,000. This year, when the cryptocurrency’s price has climbed to $5,000 per unit, you use it to purchase a $50,000 car. Assuming your adjusted basis in the cryptocurrency is $10,000, you’ll recognize a $40,000 long-term capital gain. Generally, your gain or loss is the difference between your adjusted basis in the cryptocurrency and the fair market value of the goods or services you receive in exchange for it.

Forks and drops-more information about blockchain

In some cases, a cryptocurrency owner may recognize taxable income because of certain blockchain events. Taxable income may be triggered even if you don’t conduct transactions or take any other actions with the cryptocurrency.

IRS guidance in 2019 addressed the tax implications of two types of blockchain events: “hard forks” and “airdrops.” A hard fork occurs “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.” Put much more simply, it’s when a single cryptocurrency is split in two.

A hard fork may or may not be followed by an airdrop, which the IRS describes as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” According to the guidance, when an airdrop follows a hard fork, it “results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency.” In simpler terms, it’s when “free coins” representing the new cryptocurrency are dropped into the existing cryptocurrency wallets of the owners of the legacy cryptocurrency.

If the new cryptocurrency isn’t airdropped or otherwise transferred to an account of the legacy cryptocurrency’s owner, a hard fork doesn’t trigger taxable income. On the other hand, if a hard fork is followed by an airdrop (which enables owners to immediately dispose of the new cryptocurrency), the owner recognizes ordinary income in the year the new cryptocurrency is received.

Stay current

Buying and selling cryptocurrency involves significant risk, including the possibility you could lose part or all of the money you’ve invested. Tax treatment of cryptocurrency is also subject to change. The IRS will likely continue to provide guidance on the distinctive tax issues presented by cryptocurrency. We can help you stay current on these developments and work with you to avoid unpleasant tax surprises. We have a team within the firm which work with clients in the correct reporting of the transactions.

The HoganTaylor Tax Practice

If you have any questions about the content of this publication, or if you would like more information about HoganTaylor's Tax practice, please email Tony Otto, Tax Practice Lead, at jotto@hogantaylor.com. You may also contact Denise Felber, Tax Partner, at dfelber@hogantaylor.com

INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.