Virtual currency has been in the news quite a bit lately, and is starting to get mentioned as a possible investment vehicle for those comfortable with the risk. But what is virtual currency, exactly, and how is it reported for tax purposes? While its use and popularity are growing, virtual currency may still be less understood than the use and exchange of “real” money.
Still, the IRS expects any virtual currency users to report taxable income and exchanges involving virtual currency. So, if you have any involvement with virtual currency, it is critical to understand the expectations and requirements surrounding its use.
The IRS released a virtual currency FAQ geared toward individuals who hold cryptocurrency as a capital asset but are not involved in the trade or business of selling cryptocurrency.
What is virtual currency?
Virtual currency is a digital representation of value. It is a type of unregulated digital currency that is available only in electronic form and is relayed only through designated software, computer applications, or dedicated digital wallets.
Virtual currency serves as a medium of exchange, a unit of account, and also a store of value. In some situations, it operates like “real” currency, such as coins or paper bills designated as legal tender. However, virtual currency does not have legal tender status in the United States.
Virtual currency is held within a blockchain network that is not under the control of a centralized banking authority, as with “real” money. Because it is unregulated, virtual currency — like company stock, in some regards — can experience dramatic price fluctuations, as value is determined chiefly by consumer sentiment.
It should be noted that digital currency is not the same as virtual currency since digital currency is just currency issued by a bank in digital form. Related to virtual currency, cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.
Virtual currency that has an equivalent value in real currency, or substitutes for real currency, is known as “convertible” virtual currency. Bitcoin, a popular type of convertible virtual currency, for example, can be digitally traded between users and can be purchased with, or exchanged for, U.S. Dollars, Euros, or other types of real and virtual currencies.
How is virtual currency taxed?
In 2014, the IRS issued Notice 2014-21, 2014-16 I.R.B. 938 that outlines how existing tax principles apply to virtual currency transactions. The notice explains that virtual currency is treated as property for federal income tax purposes and provides examples of how longstanding tax principles that apply to personal property transactions also apply to virtual currency.
The sale, or another type of exchange, of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, all generally have tax consequences and could result in tax liability. Since virtual currency is treated as property, general tax principles applicable to property transactions apply to transactions using virtual currency. The IRS has more information on taxes and property transactions within Publication 544, Sales and Other Dispositions of Assets.
What do virtual currency investors need to track for tax reporting purposes?
For tax purposes, it’s important to maintain records and documentation of any receipts, sales, or other exchanges involving virtual currency.
Income is generally taxable regardless of its source. As such, virtual currency transactions are taxable, just like transactions involving money exchanged for goods or services or an exchange of property for other property or services.
The IRS treats virtual currency as property, and general tax principles applicable to property transactions also apply when selling, exchanging, or otherwise transacting using virtual currency.
In general, individuals exchanging or conducting transactions using virtual currency, including buying and selling virtual currency or exchanging virtual currency, hold the virtual currency as a capital asset, and the transactions result in capital gain or capital loss.
As virtual currency is considered property, the same general principles apply. But virtual currency that’s received as compensation for services is treated the same as wages received, and the recipient then holds the virtual currency as a capital asset.
When you sell virtual currency, it is generally a capital asset, and you are required to report the transaction along with any capital gain or loss on the sale. If you exchange virtual currency held as a capital asset for services or other property, including goods or another virtual currency, you must report the transaction and any capital gain or loss resulting from the exchange.
Taxpayers must report income, gain, or loss from all taxable transactions involving virtual currency on their Federal income tax return for the year regardless of the amount or whether a payee statement (like a W-2 or 1099 form) was received.
Operation Hidden Treasure: IRS takes enforcement action
Millions of taxpayers who have failed to report their virtual currency holdings and exchanges on their tax reports may find themselves the targets of Operation Hidden Treasure.
Operation Hidden Treasure is an IRS effort to root out tax evasion among people holding and using virtual currency. Agents trained in tracking cryptocurrency and virtual currency are looking for taxpayers who omit virtual currency income on their tax returns.
The IRS first declared that virtual currencies must be treated as property for federal tax purposes in 2014. Since then, it’s become more stringent. 2020 tax reports include a question on page 1 of Form 1040 that asks: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
The IRS has stated that taxpayers need to understand their obligations involving virtual currency, and its recent actions indicate that enforcement is ramping up and awareness is spreading.
Given the IRS’ increasing cryptocurrency reporting compliance enforcement, it is essential for virtual currency holders and users to fairly report their related earnings and exchanges.
Seeking the assistance of a qualified and specialized tax advisor can help to ensure that you are correctly reporting virtual currency holdings and exchanges, as required by the IRS.
Virtual currency and tax reporting is still a relatively new practice. If you have any questions about your virtual currency holdings and how to report them when filing a tax report, we encourage you to contact our team of professionals today.