If you invested in cryptocurrency (coin) and spent some in 2017, it likely triggered a capital gain, loss, or other income, which you should report on your tax return. There is taxable income or loss on all coin transactions, including coin-to-currency trades, coin-to-coin trades, receipt of coin in a hard fork or split transaction, purchases of goods or services using a coin, and mining income. In this post, I show you how to capture the proper income amount on all coin transactions.
Capital gains and losses
Some coin deals naturally generate taxable income, including coin-to-currency trades and mining income. For example, Bitcoin sold for U.S. dollars is a noticeable capital gain or loss reportable on Form 8949. Or, when a coin miner receives a coin for his work, he naturally recognizes revenue based on the value of the coin he received.
The big problem for the IRS is that most other coin transactions are not evident for tax reporting, including coin-to-coin trades, hard fork transactions, and using a coin to purchase goods and services. The coin investor must “impute” a sales transaction to report a capital gain or loss on coin-to-coin trades and using a coin for purchases of items. Many coin investors and their accountants overlook or mishandle this reporting and underpay the IRS.
Coin is intangible property, not money
Overlooked income has to do with the fact that the IRS labeled coin “intangible property.” Coin users may call it “digital money,” but it’s not money. That’s the critical difference: Each use of money is not a taxable event. Imagine having to report a capital gain or loss every time you purchased an item or asset with cash or a credit card. That would be ridiculous.
Coin-to-currency sales are capital gains and losses
Most taxpayers comprehend that if they purchased Bitcoin in 2016 for $10,000 and sold all of it in 2017 for $30,000, they should report a capital gain of $20,000 on their 2017 tax return form 8949. If the investor held the coin position for one year or less, it’s considered a short-term capital gain taxed at ordinary tax rates (up to 39.6% for 2017). If the position was held for more than one year, the long-term capital gain rate (up to 20% for 2017) applies.
Coin-to-coin trades don’t qualify for deferral of income
Many taxpayers and preparers delay capital gains income on coin-to-coin trades by inappropriately classifying them as a Section 1031 “like-kind exchange,” where they may defer income to the replacement position’s cost basis.
I do not think coin-to-coin trades qualify for Section 1031 transactions as they fail the two primary requirements. First, Bitcoin does not qualify as like-kind property with another coin. Second, coin-to-coin trades primarily executed on exchanges are not “direct two-party exchanges” or “multi-party exchanges using a qualified intermediary.” (See Cryptocurrency Traders Risk IRS Trouble With Like-Kind Exchanges.)
Coin splits in hard forks are taxable income
Bitcoin had a hard fork in its blockchain on Aug. 1, 2017, dividing into two separate coins, Bitcoin vs. Bitcoin Cash. Each holder of a Bitcoin unit was entitled to arrange receipt of a unit of Bitcoin Cash.
Some Bitcoin holders did not gain immediate access to be able to sell Bitcoin Cash, so they may feel it’s okay to defer income on the fork transaction until they gain such access. For example, the most significant U.S.-based coin exchange, Coinbase, did not initially support Bitcoin Cash. Before the fork date, Coinbase informed its customers how to arrange receipt of Bitcoin Cash outside of Coinbase. For this reason, the IRS could argue the holder did, in fact, have “constructive receipt of income.”
A Wall Street Journal article, Bitcoin’s Civil War: What You Need to Know, stated the initial fair market value of Bitcoin Cash on Aug. 1, 2017, was $266 per unit. Taxpayers should report $266 per unit or another price that they established, as “Other Income” or as a capital gain on Form 8949. (See How To Report Bitcoin Cash And Avoid IRS Trouble.)
Not every hard fork coin transaction should be treated the same. A very successful coin trader told me it would be more equitable to value new coin received in hard fork transactions with zero cost basis. He pointed out that hard forks are uncontrollable, contentious and they frequently happen, that their initial fair market value varies significantly across coin exchanges, the new coin may not even trade for several days, and that each new coin acts differently with the original coin. For these reasons, he said it’s nearly impossible to establish a balanced formula and value for reporting income on the new coin. Even Bitcoin Cash had a wide-ranging initial trading price on exchanges. (See Blockchain Orphaned Blocks.)
On Oct. 24, 2017, Bitcoin had another hard fork, splitting off Bitcoin Gold. There are more than 4,000 coins; many were created in hard fork transactions.
Example: Purchasing goods and services with coin
On Jan. 1, 2017, Joe bought 100 Bitcoins at a price of $998 each, for a total cost basis of $99,800. On June 1, 2017, when the price of a Bitcoin unit was $2,452, Joe used one Bitcoin to purchase a new computer for an invoice price of $2,452.
Without realizing it, Joe triggered a reportable short-term capital gain on his 2017 Form 8949. The sales proceeds are $2,452, representing the fair market value of the one bitcoin he used to purchase the computer. His cost basis for that one Bitcoin unit used is $998, so his net short-term capital gain is $1,454. If Joe uses the computer in his business, he will deduct $2,452 as an expense.
The IRS is taking action against coin exchanges and investors
The IRS was late in recognizing a coin “tax gap,” and it recently commenced an aggressive campaign to catch coin investors with under-reported income.
The IRS successfully served a John Doe summons (the roughest kind) on Coinbase, and we are awaiting the results of its investigation. You should respect the tax rules for all types of coin transactions to avoid an IRS exam, which could lead to an assessment of back taxes, interest expenses, and penalties. Accuracy-related penalties include a negligence penalty of 20% and a substantial understatement penalty of 20% if you understate your income by 10% or more.
In March 2014, the IRS issued long-awaited guidance (IRS Notice 2014-21) declaring coin “intangible property” and addressing some other tax questions. But, many issues remain uncertain including whether coin-to-coin trades may qualify for a Section 1031 like-kind exchange, how and when to report hard fork coin transactions, how and when to select permissible accounting methods, whether wash sale losses on securities apply to coin, and more.
We cannot hold tax return filings waiting for new IRS guidance, which may not come at all. Our position is that coin traders cannot use Section 1031 on coin-to-coin trades executed on coin exchanges. Hard fork income is often taxable income when the new coin is received. Section 1091 wash sale loss rules and Section 475 MTM do not apply to coin because it’s not a security. Coin traders should select a permissible accounting method in advance of the year or contemporaneously with the trade — not after the fact.
In my next post, Coin Traders Should Consider These Two Tax Accounting Solutions, I discuss coin accounting solutions and review two leading programs.
If you have questions, please contact us or another expert in coin taxation.
Darren Neuschwander, CPA contributed to this blog post.