Unless you’ve been living under a rock, you’ve probably heard about Bitcoin and how more and more people are jumping into it. But what is a Bitcoin? What is cryptocurrency? And more importantly for our purposes, how is it all taxed?
Bitcoin is a form of virtual currency that is created, traded, and often stored online. It’s decentralized, so no country or person controls all of the Bitcoin. Some companies have started accepting payment in Bitcoin including Overstock.com, Microsoft, Paypal and Tesla. Bitcoin is itself a type of cryptocurrency, which encompasses hundreds of other different digital currencies. Bitcoin, and many other coins, run on blockchain technology, which is essentially a digital ledger of all of the bitcoin transactions. Many online sites let you purchase Bitcoin and other cryptocurrency for US Dollars, and many exchanges let you exchange cryptocurrency coins for other different coins, which may include Litecoin, Ethereum and many others.
But we’re not technology lawyers here at Hoffman & Associates, we’re tax lawyers. How do these millions of dollars of Bitcoin profits get taxed?
The IRS gave us some guidance with Notice 2014-21, in which they described some of the basic tax principles of cryptocurrency. The IRS refers to cryptocurrency as “virtual currency,” and treats it as “property,” which means the IRS does not allow it to be taxed as foreign currency, since it is not legal tender.
What this means is that cryptocurrency gains are taxed somewhat similarly to stock. There will be no tax on any gain or loss until a recognition event occurs. If the cryptocurrency is held for less than a year, short-term capital gains rates will apply (the same rate as ordinary income tax rates.) However, if the cryptocurrency is held for longer than a year, the gain or loss will be taxed at a lower rate, which is 15% for all but the highest earners, who pay 20%.
To be clear, not all cryptocurrency tax circumstances will qualify for the lower long term capital gains rate. For example, if you are paid wages from work in cryptocurrency, that income will still be ordinary income. If someone “mines” the cryptocurrency, which means uses their computer to solve complex math problems to receive cryptocurrency, that income will also be treated as ordinary income.
Currently, a lot of the smaller cryptocurrency coins (called “altcoins”), cannot be purchased with US dollars, so one would have to buy a more popular coin with US dollars, then use an exchange to buy the altcoins. For example, someone may buy one Bitcoin and a few weeks later, after it has appreciated, exchange it for a certain amount of another coin.
Although many taxpayers may expect this to be a non-taxable transaction since they never cashed out to US dollars, it’s likely that the IRS would not agree. Although the IRS has never specifically ruled on the taxation of such a transaction, most practitioners believe it is clear that such a transaction is taxable.
The section of the Internal Revenue Code that would possibly allow for deferral of tax is IRC Sec. 1031, which allows for deferral of taxes when like-kind property is exchanged for other like-kind property to be held in a trade or business or for investment.
For example, if a taxpayer swaps one piece of investment real property for another with the same value, there will be no tax on that transfer, even if the value of the property at the time of the swap is higher than the taxpayer’s basis in the property.
However, IRC Sec. 1031(a)(2) does not allow the like-kind tax deferral to be applied to stocks, bonds, notes, or securities. It is very likely that the IRS will treat cryptocurrency similarly.
Even a purchase using cryptocurrency will trigger a tax event, which has the potential to complicate the use of cryptocurrency as currency forever. Who would want to buy something small online if they’d have to keep track of the tax consequences?
In the next cryptocurrency tax article, we will discuss current and proposed legislation and cases related to the taxation of cryptocurrency.
Should you have any cryptocurrency tax questions, do not hesitate to contact us at 404-255-7400 or hoffmanestatelaw.com.