Category: Cryptocurrencies

If You Traded Bitcoin, You Should Report Capital Gains To The IRS

February 16, 2017 | By: Robert A. Green, CPA


If You Traded Bitcoin, You Should Report Capital Gains To The IRS

The IRS considers cryptocurrencies, including Bitcoin, to be “intangible property.” Investors and traders holding cryptocurrency as a capital asset should use capital gain or loss tax treatment on sales and exchanges, with the realization method. For example, if you buy Bitcoins with U.S. dollars and later sell them for U.S. dollars, a capital gain or loss needs to be reported on that transaction. An exchange of one cryptocurrency for another cryptocurrency is a taxable sale transaction, even though U.S. dollars are not involved in the transaction.

Americans also trade Bitcoin or leveraged Bitcoin contracts on Bitcoin exchanges, and they should report realized capital gains and losses on each trade, even if the trader doesn’t convert underlying Bitcoin back into U.S. dollars.

It’s similar to having a foreign-based brokerage account, denominated in a foreign currency (i.e., Euros), where a trader buys and sells European equities held in Euros, and does not convert Euros back to U.S. dollars during the year. Two potential choices for tax reporting: Convert Bitcoin to U.S. dollars on each purchase and sale transaction using the Bitcoin market price that day denominated in U.S. dollars, or perhaps the IRS will allow using Bitcoin as a functional currency, using an average Bitcoin vs. U.S. dollar conversion rate for the tax year.

The CFTC does not permit American retail customers to trade leveraged Bitcoin contracts on unregistered Bitcoin exchanges. (Read my related blog post: If You Want To Trade Bitcoins, First Learn CFTC Rules.)

Whether it’s legal or not under CFTC regulations, the IRS requires American resident taxpayers to report Bitcoin trading income and losses worldwide on U.S. resident tax returns. It doesn’t matter whether you repatriate funds back to the U.S., or not.

IRS guidance on cryptocurrency
In March 2014, the IRS issued long-awaited guidance (IRS Notice 2014-21) labeling cryptocurrency, including Bitcoin, “intangible property.” Investors and traders hold Bitcoin as a capital asset, so it receives capital gain and loss treatment. The AICPA and others have requested further guidance on virtual currency from the IRS. For investors and traders, I have a few unresolved questions below.

Intangible property is not a security, yet it seems logical that several tax rules for investors and traders are similar, whereas a few others are not.

Cryptocurrency is like securities in these cases

  • Use the realization method for sales of cryptocurrency held as a capital asset, which means you defer reporting of the capital gain or loss until closing the position.
  • Don’t use mark-to-market accounting at year-end, which means you don’t report unrealized gains and losses.
  • Use holding period rules to distinguish between short-term vs. long-term (12 months or longer) capital gains and losses. The long-term capital gains rates are lower than short-term rates, taxed as ordinary income.
  • The $3,000 capital loss limitation against other income applies.
  • Report each trade separately on Form 8949 (Sales and Other Dispositions of Capital Assets); we assume the IRS does not permit summary reporting. It’s OK to attach a report from your broker listing an accounting for each cryptocurrency trade.

Cryptocurrency is unlike securities in these cases

  • I don’t think you’ll have to make wash sale loss adjustments since Section 1091 wash sale rules only mention securities, not intangible property. Hopefully, the IRS will clarify this issue.
  • Traders qualifying for trader tax status may not elect Section 475 ordinary gain or loss treatment on cryptocurrency. Section 475 covers securities and commodities, not intangible property.
  • Cryptocurrency is not sovereign currency or forex with Section 988 ordinary gain or loss treatment, or Section 1256(g) foreign currency contract treatment. The IRS and CFTC call cryptocurrency “currency,” but not “foreign currency.”

Onshore and offshore cryptocurrency exchanges do not issue American investors or traders a Form 1099B.

Read my prior blog post: IRS Guidance On Bitcoin Transactions.

Nadex offered Bitcoin binary contracts in 2016
The North American Derivatives Exchange, Inc. (Nadex), a U.S.-based CFTC-regulated derivatives exchange, offered Bitcoin binary contracts for part of 2016. On Dec. 16, 2016, Nadex filed a Self-Certification to Delist Bitcoin.

Over the past several years, Nadex issued Americans a Form 1099B for Section 1256 contracts. That’s an advantageous tax treatment with lower 60/40 tax rates, and I doubt whether it’s correct to use Section 1256 tax treatment for Bitcoin binary contracts. (Read Tax Treatment For Nadex Binary Options.)

Bitcoin and foreign bank account reporting
U.S. residents with a foreign bank, brokerage, investment and another type of account (including retirement and insurance in some cases) who meet reporting requirements must e-file FinCEN Form 114, Report of Foreign Bank and Financial Account. If your foreign bank and financial institution accounts combined are under $10,000 for the entire tax year, you fall under the threshold for filing FinCEN Form 114.

The IRS allowed taxpayers to exclude Bitcoin from 2013 foreign bank account filings. It’s not clear if the IRS continues to allow an exclusion of Bitcoin, or Bitcoin derivative contracts, on current year FinCEN 114 filings. Suppose you have Bitcoin or Bitcoin derivative contracts held at a foreign Bitcoin exchange. When in doubt, and considering significant penalties for non-compliance, it’s probably wise to include these Bitcoin accounts on FinCEN 114. (Read Bitcoin Is Not Reported On 2013 FBARs.)

For another update on cryptocurrency tax treatment, read Taxation of Virtual Currency, Jan. 16, 2017, Bloomberg, by Elizabeth R. Carter.

If You Want To Trade Bitcoins, First Learn CFTC Rules

| By: Robert A. Green, CPA

The CFTC requires counterparties, including brokers and exchanges, doing business with American retail customers to register if they offer “leveraged” or “financed” financial products, including derivatives. The CFTC brought an enforcement action against unregistered Bitfinex of Hong Kong because they offered leveraged cryptocurrency contracts to American retail customers. Several other unregistered offshore exchanges offer leveraged cryptocurrency contracts to American retail customers. Many Americans trade cryptocurrency on exchanges that do not provide leveraged contracts, and that seems okay.

Bitcoin is the most famous cryptocurrency, and there’s been significant price volatility the past few years. That’s attracted American retail traders to Bitcoin exchanges offering leveraged trading and derivative products based on Bitcoin price movements.

In this post, I discuss CFTC regulation for Bitcoin counterparties (exchanges and brokers), and in my related post, I cover tax treatment for trading Bitcoin. (See If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)

Is Bitcoin trading legal for American retail customers?
Some American retail customers trade leveraged or financed cryptocurrency contracts with counterparties that are not registered with the Commodity Futures Trading Commission (CFTC) or another U.S. regulator to allow cryptocurrency trading by American retail customers. I asked the CFTC and National Futures Association (NFA) if that is legal, and both said CFTC regulations for American retail customers apply to counterparties, not American retail customers. Does that imply that leveraged Bitcoin and cryptocurrency trading may be legal for American retail customers, and illegal for counterparties? Perhaps, yes, but I am not sure. It’s risky for American retail customers to trade leveraged Bitcoin contracts or another leveraged cryptocurrency because the CFTC may take enforcement action against their counterparties as it did against Bitfinex (see below). Maintain control of Bitcoin wallets to avoid some counterparty risk with regulators.

CFTC regulations
The Commodity Futures Trading Commission (CFTC) requires counterparties, including brokers and exchanges, to register with the CFTC if they offer leveraged or margined financial products to American retail traders. That includes some Bitcoin exchanges and Bitcoin derivative products.

If a forex dealer wants to do business with American retail traders on leveraged forex contracts off-exchange, the CFTC requires the forex dealer register with the CFTC, SEC or bank regulator. There is CFTC-registered Retail Foreign Exchange Dealers (RFED), and CFTC-registered Futures Commission Merchant (FCM) Forex Dealer Members.

The CFTC considers Bitcoin a “currency,” but not a “foreign currency.” The CFTC says Bitcoin is not forex, so it doesn’t fall under the forex regulations. The CFTC also refers to Bitcoin as a “commodity.”

The North American Derivatives Exchange, Inc. (Nadex), a U.S.-based CFTC-regulated exchange, offered leveraged Bitcoin binary contracts until it discontinued that product at the end of 2016. On Dec. 16, 2016, Nadex filed a Self-Certification to Delist Bitcoin.

Bitcoin exchanges offering leverage try to escape CFTC jurisdiction
Bitcoin exchanges have sought exemption from CFTC jurisdiction in claiming traders are “making and taking delivery” of each trade on their “exchange,” by transferring the title into Bitcoin wallets. The CFTC does not regulate private transactions in commodities, or forward contracts when made for delivery within 28 days. For example, a farmer may sell wheat to a cereal manufacturer for immediate delivery, or with a forward contract. A warehouse receipt is evidence of delivery.

CFTC jurisdiction applies to counterparties offering futures, options, derivatives, and financed (or leveraged) retail transactions for future delivery. In the CFTC enforcement case cited below, the CFTC explained how leveraged trades in the spot Bitcoin market with an American retail customer fell under CFTC jurisdiction as a financed retail transaction. The CFTC also disagreed that Bitfinex made full delivery of Bitcoin to traders.

Two CFTC enforcement cases against Bitcoin exchanges
Bitfinex in June 2016, and Coinflip in September 2015. Read CFTC vs. BFXNA INC. d/b/a BITFINEX and CFTC Bitfinex Enforcement Action, an analysis by law firm Clifford Chance. Here are some excerpts from the Clifford Chance client briefing:

  • “The Order expands the CFTC’s regulation of bitcoin and other cryptocurrencies into spot markets under certain conditions.”
  • “The result is that spot trades qualifying as financed retail transactions will be regulated as if they were futures trades.”
  • “The Exception does not apply since the bitcoins were not actually delivered. In finding lack of actual delivery, the CFTC looked to the fact that at all times Bitfinex held the private keys needed to access the wallet where bitcoins were held.”

On-exchange vs. off-exchange
On-exchange means a CFTC-registered U.S. futures, options or derivatives exchange like the CME, CBOE, ICE, NYMEX and NADEX.

On-exchange also includes foreign futures and options exchanges, providing the CFTC issued a “Part 30 Letter” granting the foreign exchange permission to solicit accounts with American retail customers. The exchange must demonstrate similar rules as in the U.S. including posting prices, setting margin requirements, meeting capital adequacy, and more. (See a list of CFTC Part 30 Letters on the CFTC website.)

The CFTC’s mission is to protect American retail customers
The CFTC prefers leveraged trading transactions for American retail traders conducted on-exchange, so the exchange may act as the counterparty to both buyer and seller, who otherwise do not know each other. With off-exchange forex, the CFTC-registered RFED and Forex Firms are the counterparties.

Consider the infamous failure of the largest (at the time) Bitcoin exchange, Mt. Gox, which filed for bankruptcy protection in Japan in 2014. The CFTC is trying to protect American retail customers from these types of losses.

Exemptions for ECP and ECE
Eligible Contract Participants (ECP) who meet certain high net worth requirements are “institutional” and exempt from CFTC regulations for American retail customers. ECP can trade off-exchange leveraged financial products, including Bitcoin derivatives. Eligible Commercial Entities (ECE) are exempt, too. (For a definition of ECP, click here and for ECE, click here.)

Republicans are interested in scaling back Dodd-Frank regulations
President Trump, his administration officials, and the GOP leaders in Congress have indicated they want to scale back elements of the Dodd-Frank Act. It’s conceivable they could reduce some of the CFTC limitations on American retail customers trading leveraged financial products off-exchange.

Tax reporting
Whether it’s legal or not under CFTC regulations, the IRS requires American resident taxpayers to report Bitcoin trading income and losses worldwide on U.S. resident tax returns. It doesn’t matter whether or not you repatriate funds back to the U.S. (See my blog post: If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)

Bitcoin is a hot commodity, but how is it taxed?

December 3, 2013 | By: Robert A. Green, CPA

Buttressed by an Internet craze, the price of bitcoin has skyrocketed this past year from $17 to over $1,200. Pundits expect significant price volatility in 2014 as well.

While the Federal Reserve gave tacit approval, stating “virtual currencies like bitcoin have legitimate uses and should not be banned,” the IRS has not yet issued tax guidance. Despite the lack of guidance, income from bitcoin transactions must be reported.

What’s the bitcoin tax treatment for traders?
There are two possibilities how bitcoin should be treated for tax purposes: either it is an (1) intangible asset, or (2) a foreign currency. The problem with saying that it’s a currency is that it is not issued by a government, and traditionally currencies are legal tender issued by governments. In California Bankers Assn v. Shultz, the Supreme Court stated (in a non-tax context): “‘Currency’ is defined in the Secretary’s regulations as the “coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.” The IRS has not said its opinion, but both Canadian and Swedish tax authorities are treating bitcoins as an asset. Also, the German Finance Ministry says bitcoin is not classified as e-money or a foreign currency, but is rather a financial instrument under German banking rules. It is our sense that unless Congress enacts legislation to treat bitcoins as a foreign currency, the IRS will treat bitcoins as an asset.

If you buy bitcoin for purposes of appreciation and then sell it, then if (1) bitcoin is an asset, you will have capital gain and loss, and (2) if bitcoin is a foreign currency, then under Section 988 you will have ordinary income and loss.

Is bitcoin a commodity?
There is no definition in the Internal Revenue Code of “commodity.” Black’s Law Dictionary 342 (4th ed. 1968) defines commodity: a movable article of value that can be bought or sold. A bitcoin is not movable property, so arguably it’s not a commodity. But at the Senate hearing, academics and financial industry players warned that bitcoin could be regulated as a commodity if market volatility continues. Such financial regulation may or may not impact the tax treatment.

Most bitcoin investors and traders will prefer capital gains tax treatment
After the astronomical rise in bitcoin this past year, most investors and traders may prefer capital gains and loss tax treatment. Consider this example: An American investor bought bitcoin at $17 just over 12 months ago and he sold it recently for $1,200. Is he entitled to significantly lower long-term capital gains tax rates of up to 20% in the top bracket and up to 15% in the second top bracket? That’s 20% lower than the top ordinary rates of 39.6% and 35%.

In this example of incredible appreciation, investors and traders will prefer that the IRS views their bitcoin transactions as trading in a commodity or other capital asset held for price appreciation. As long as the investor did not acquire the bitcoin as part of his business or for personal reasons this tax treatment seems safe to deploy on 2013 tax returns — until the IRS says otherwise.

It’s important to also consider tax treatment for commodities sold in a business vs. trading in commodity futures contracts. A farmer sells his wheat and reports ordinary gain or loss treatment in his trade or business. Conversely, a commodity futures trader holds “capital assets” subject to capital gain or loss treatment. Regulated futures contracts benefit from lower 60/40 capital gains tax rates (60% is a long-term capital gain — even on a day trade — and 40% is ordinary tax rates).

Say a trader’s regulated futures contract expires and he takes delivery of bushels of wheat. If he sells those bushels of wheat in less than 12 months, he receives short-term capital gains treatment, not ordinary gain or loss treatment or lower 60/40 tax rates since the bushel does not qualify as a Section 1256 contract.

Can bitcoin traders use ordinary loss tax treatment in Section 475?
What goes up fast and irrationally may also go down fast and irrationally. New investors may wind up with big trading losses and they may wish for ordinary loss treatment instead of $3,000 capital loss limitations and large capital loss carryovers.

As the bitcoin trading market expands, some bitcoin traders may be able to achieve trader tax status (business treatment) on trading that asset class. It is not clear whether they can make a Section 475 MTM election for trading bitcoin to have business ordinary gain or loss treatment. Section 475 allows “Traders in Securities and or Commodities” to make the election. The term “commodities” above really refers to trading Section 1256 contracts or regulated futures contracts; Section 475 does not seem to include bitcoin. However, if bitcoin becomes regulated as a commodity, it may qualify for Section 475 treatment.

A potential case for using Section 988 ordinary gain or loss treatment
If you don’t qualify for trader tax status in bitcoin, perhaps you can convince the IRS to respect the Fed’s label of “virtual currency,” and argue your bitcoin trades qualify for application of Section 988 (foreign currency transaction) ordinary gain or loss treatment.

Section 988 is the default tax treatment for spot forex trades, which is a huge trading marketplace. Spot forex traders write off trading losses in full as ordinary losses on line 21 of Form 1040 (Other Income). If they have trader tax status, they use Form 4797 Part II business ordinary loss treatment, which feeds into Net Operating Loss (NOL) calculations.

Section 988 allows forex traders and investors, but not manufacturers and other operating businesses, to file a contemporaneous internal opt-out or capital gains election. Many forex traders file a capital gains election and navigate their way into lower Section 1256g lower 60/40 tax rates, too. Section 988 does not allow a capital gains election on holding physical currency and that would apply to holding bitcoin, too if Section 988 were to apply. Section 988 rules for forex traders are complex and beyond the scope of this article.

Bitcoin as a digital currency
In general, American vendors accepting bitcoin as a digital currency in their trade or business should report bitcoin transactions as they would with a foreign currency. Simply translate the foreign or digital currency back into U.S. dollars on the date of receipt. There are no grounds to defer recognition of these transactions simply because it’s in bitcoin.

Holding bitcoin in your business
What happens if a trade or business decides to hold bitcoin for appreciation after acquiring it in a regular business transaction? Is it ordinary gain or loss from holding a commodity in your trade or business, or a capital gain or loss from holding onto a commodity or capital asset for appreciation? Both can be the case and it depends on intention, facts and circumstances.

In the earlier example, the farmer stockpiles wheat in a grain elevator, perhaps waiting for higher prices. The farmer may also hedge wheat prices in the futures market. Under the “hedging rule,” the wheat farmer still has ordinary gain or loss on storing and hedging wheat.

Also, consider the example of a manufacturer who holds foreign currency reserves for later use in foreign markets or for appreciation. The manufacturer also may hedge his foreign currency in the futures market. Like the farmer, the manufacturer has ordinary gain or loss on all these transactions.

An Internet vendor is not a commodity farmer of bitcoin and it’s conceivable that he could segregate bitcoin as a commodity or capital asset held for investment.

Bottom line
Bitcoin is a hot asset for traders and investors and you should learn the tax rules before you plow your money in. If you acquired bitcoin in your business, make sure you reported your sale transactions correctly.