What is Cryptocurrency and how does it affect your taxes?

Posted June 2020

Cryptocurrency is a digital or virtual currency. Virtual currency is defined by the IRS in Revenue Ruling 2019-24, as “a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency.” Cryptocurrency has no centralized or administrative storing house; all the transactions are stored globally in multiple locations at once. Cryptocurrency is usually stored in electronic Wallets and accounts whereby the only person with the ability to access the currency is the holder of the encryption key.

Blockchains, which are organizational methods for ensuring the integrity of transactional data, is an essential component of many cryptocurrencies. Blockchains are a series of blocks of information created by proof of work by computer nodes solving algorithmic puzzles. The transaction history cannot be changed without alerting all the other nodes on the network.

Cryptocurrency can be bought and sold similar to stock securities on multiple exchanges throughout the world. One of the perks of exchanges in the virtual world is that they can take place immediately, giving 24-hour access to trading. This results in no more working hour constraints for the banks and Wall Street. Cryptocurrency can be spent in exchange for services or goods with vendors that accept cryptocurrency, without going through a financial institution. It is a pure peer to peer exchange system. However, the exchange of cryptocurrency for services or goods could result in a taxable transaction. In addition, trading one type of cryptocurrency for another is a taxable transaction, even if no cash is exchanged.

Coins, such as Bitcoin, Ripple, Ethereum, Libra, and several others can also be mined, or earned by proof of work. Mining for coins on the network and solving the algorithms would constitute a trade or business. The coins earned would be treated as ordinary income. The value of the coins would be based on fair market value in US Dollars at the date of receipt. The ordinary income would be subject to Self-Employment tax.

Currencies purchased and sold on an exchange would be treated similarly to sales of stock. These transactions would be reported on the Schedule D, capital gains and losses, also based on fair market value at the date of sale, and basis would be fair market value on date of receipt, in US Dollars.

There are a number of other complex cryptocurrency transactions that are not discussed in this article, but may constitute a taxable transaction. Some of these transactions include, hard forks, airdrops, lost key reporting, exchange hacks, dead coins, coinopsy, and freezes. Look for our upcoming article regarding details on complex cryptocurrency transactions.

The IRS is hoping to crack down on compliance reporting for cryptocurrency. Stanfield + O’Dell has a team of tax professionals well versed in cryptocurrency and compliance. Please contact us if you have any questions or would like to discuss your cryptocurrency holdings.