Yes, Your Bitcoin Gains Are Taxable
Summary
- You need to declare virtual-currency transactions on your 1040—the IRS has been communicating its intent to enforce such reporting
- Virtual currency is treated as property—upon sale, the difference between the price you paid and the cash received is the recognized gain.
- If you receive cryptocurrency as a gift, there are no tax consequences until you sell or exchange it; then capital gain treatment applies
- Virtual currency received for services rendered is treated as W-2 or self-employment income, depending on the relationship between employer and employee
- Don’t expect much federal help if your Bitcoin is lost, stranded, or hacked
Did you happen to buy Bitcoin a year or so ago? Good for you! As you probably know, its value has increased by nearly 700% since the beginning of 2020, reaching an all-time high of $58,000 as of March 11th [1]. Investors are very fortunate to have participated in this upside, sure. But many are unaware of the IRS’s virtual currency compliance requirements, for which preposterous penalties can apply—like jail time plus a $250,000 fine. Do you really want to hand over your liberty and treasured gains to the government’s coffers for this slight infringement? Of course not. This article will tell you how to properly disclose the necessary data to the tax authorities as we head into the 2020 filing season. Though I’m emphasizing Bitcoin here, these reporting requirements apply to any virtual currency.
Disclaimer: This post is for informational purposes only and should not be construed as tax, legal, or investment advice. The area of cryptocurrency taxation is constantly evolving and is not black and white. Speak to your own tax expert, CPA, or attorney on how you should treat taxation of digital currencies.
If you engaged in a transaction involving any virtual currency in 2020, the first thing to remember is to truthfully answer the question on the first page of your IRS 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?” This is the IRS’s way of addressing the anonymity of blockchain transactions—by requiring taxpayers to confirm or deny having participated in them.
Blockchain technology is a peer-to-peer virtual ledger that makes digital asset records fixed, and most significantly, does not involve a third-party intermediary. Before the existence of cryptocurrency, digital transactions required a trusted third party to act as a middleman. The benefit of this new virtual ecosystem is that a Bitcoin user doesn’t need to trust anyone outside of the financial network to validate transactions. Because all transactions are public, anonymous, and immutable, each transaction is continuously validated by every user simultaneously[1], rendering middlemen effectively useless.
So how does participating in these transactions impact your tax-compliance responsibilities? First, realize that nondisclosure is a bad idea, even though third-party intermediaries are not involved—meaning no one has reported your transaction to the IRS. Normally, financial intermediaries report transactions that you are involved in to the IRS. The IRS thus knows to expect to see a sale of stock on your 1040 Schedule D. Bitcoin and other virtual-currency transactions escape this because, as mentioned above, no third-party intermediaries are involved.
Human nature may support the thinking that what the IRS doesn’t know won’t hurt them. However, nondisclosure will almost certainly come back and haunt you.
The IRS has not been shy about communicating its intent to enforce reporting of cryptocurrency activity. The commissioner has repeatedly indicated that cryptocurrency investigations are underway by the IRS’s Criminal Investigation Division. Anyone convicted of tax evasion (a felony) is subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000.[2]
Beginning July 2019, the IRS sent letters (Letter 6173, Letter 6174-A, and Letter 6174) to 10,000 taxpayers with known cryptocurrency transactions to alert noncompliant filers and to place them on notice. The IRS has also started audits of taxpayers they believe are hiding something.[3] If you have received one of these letters, the severity and action required are summarized as follows:
- Letter 6173 – The jig is up! The IRS is fairly certain that you have not complied. Respond and correct your return or face a potential audit.
- Letter 6174-A – The IRS knows you have a cryptocurrency account, but they are unsure if you reported correctly. No response required unless corrections are needed.
- Letter 6174 – The IRS knows you have a cryptocurrency account and they are sending information on how to report for taxes. No response required unless corrections are needed.
The primary drivers of tax consequences for virtual currency are the exchange of virtual currency for fiat currency[4] (capital gain) and the receipt of currency in exchange for performing services.
Capital gain treatment: From a tax standpoint, the overarching principle is that virtual currency is treated as property.[1] This means that upon sale of the property, the associated gain on the coin—that is, the difference between the price you paid and the cash received once sold—is the recognized gain. It’s important to keep track of how long you’ve held the crypto because it will affect whether the transaction is treated as short-term or long-term. Similar to a sale of stock, if you’ve held on to the coin for longer than one year, the gain is considered long-term and qualifies for the long-term capital gain rate. If the currency was held for less than a year, the gain will be considered short-term and taxed at your marginal tax rate.
Note that special considerations must be made when the currency is received as a gift. There are no immediate tax consequences if you receive cryptocurrency as a gift. Instead, once you sell or exchange the currency, capital gain treatment will apply. At that time, certain determinations must be made, particularly with regard to your basis. Your basis in virtual currency received as a gift differs depending on whether you have a gain or a loss when you sell it.
- For a gain, your basis is equal to the donor’s basis plus any gift tax the donor paid on the gift.
- For a loss, your basis is whichever of these two considerations is the lesser: the donor’s basis, or the fair market value of the virtual currency at the time you received the gift.
- If you do not have any documentation to substantiate the donor’s basis, then your basis is zero.
- The holding period (long-term versus short-term) of the coin transfers from the original holder to the beneficiary. So if the coin was sold more than a year from its original purchase by the donor, the currency qualifies for long-term capital gain treatment.
Performance of services: People sometimes pay for services in virtual currency. If, for example, you received cryptocurrency for mowing your neighbor’s lawn or washing their car, you will have income for the coin’s value on the day you received it. Payments for services are considered wages if there is an employer/employee relationship, or self-employment income if an independent contractor relationship exists. If an employment relationship exists, then general withholding requirements must be followed, and a W-2 would be issued at the end of the year. If it’s an independent contractor relationship, your Bitcoin is considered self-employment income. Say you charge $600 in Bitcoin for lawn mowing. The person who hired you will be responsible for submitting a 1099 to you and the IRS. The value of the coin when received ($600) should be included in your taxable income and will also be your basis for the currency when you eventually sell it. Michael Ashley Schulman, Chief Investment Officer for Running Point Capital Advisors, recently wrote a piece giving his assessment on Bitcoin investments[2]. One factor he highlighted that is important to remember before you invest in Bitcoin is the fact that Bitcoin is highly susceptible to
loss or theft. A digital wallet can get hacked, a password can be forgotten, or a mistake made in setting up a hard wallet. Amazingly, approximately 20% of the outstanding supply of Bitcoin, or $140 billion, “appears to be in lost or otherwise stranded wallets.”[1]
Lost, stranded, hacked Bitcoin: Is tax relief available for holders of lost, stranded, or hacked wallets? Not much from a federal standpoint, but each situation is different. It’s important to identify the type of loss from a tax standpoint so that you can apply your situation correctly. The three types are:
- Casualty losses – damage, destruction, or property loss resulting from a sudden, unexpected, and unusual event. Coins lost from a forgotten password would fall under this category. As of the 2017 Tax Cuts and Jobs Act, these types of itemized deductions no longer apply for federal purposes. However, you should consult with your tax advisor about any deductibility on your state tax return.
- Theft losses – If your virtual wallet was hacked or stolen, you appear to be in the same boat as those who forgot their passwords or otherwise lost their wallet: no federal help; check on your state’s laws.
- Investment losses – Generally speaking, this treatment is reserved for when you sell a coin for less than you purchased it for, not for lost or hacked-coin situations.
Virtual currencies held in foreign accounts may require reporting under the Foreign Account Tax Compliance Act, and a FinCEN Form 114 may be required to be filed. Consult your tax advisor if you think this could apply to you.
As you can see, there are a number of factors to consider before you invest in virtual currency. Most importantly: Even if you think the IRS will not find out about your investments, it’s better to preemptively disclose this information on your return and avoid the consequences for noncompliance.
If you are invested in or considering investing in Bitcoin or other cryptocurrencies, we at Running Point Capital Advisors can leverage the resources of our coordinated multifamily office team. We have experienced professionals in financial planning, investment, estate preparedness, tax planning, and accounting, and we all work together on your behalf. We are happy to discuss appropriate portfolio size and risk allocations as well as the pros and cons of the various investment options available to you.
Todd Stern
Tax Manager
[1] https://www.euromoney.com/learning/blockchain-explained/how-transactions-get-into-the-blockchain
[2] https://www.irs.gov/newsroom/irs-reminds-taxpayers-to-report-virtual-currency-transactions
[3] keimtaxlaw.com/the-irs-breaks-its-silence-on-cryptocurrency-and-it-isnt-good-news
[4] Fiat currency is legal tender whose value is backed by the government that issued it.
Disclosure: The opinions expressed are those of Running Point Capital Advisors, LLC (Running Point) and are subject to change without notice. The opinions referenced are as of the date of publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Forward looking statements cannot be guaranteed. Running Point is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Running Point’s investment advisory services and fees can be found in its Form ADV Part 2, which is available upon request. RP-21-03
