Got crypto?
Beware of tax surprises when dealing with cryptocurrencies

In recent years, interest in cryptocurrencies — such as Bitcoin and Ethereum — has exploded. Once viewed as a novelty, these currencies are increasingly entering the mainstream as an investment or an alternative currency. If you’ve jumped on the cryptocurrency bandwagon, it’s important to understand the tax implications.

Owners are often surprised to discover that when they use cryptocurrency to purchase goods or services, they may trigger capital gains or losses they must report on their tax returns. Even investors who buy and hold cryptocurrencies may have to report taxable income when certain events take place on the blockchain or other digital ledger system on which cryptocurrency transactions are recorded.

Currency vs. property

The IRS treats cryptocurrency (also called virtual currency) as property. That means when you sell cryptocurrency in exchange for traditional currency, you must recognize a capital gain or loss. The amount of that gain or loss, as with other types of property, is the difference between the sale price and your adjusted basis in the cryptocurrency. Generally, your basis is the amount you spent (in U.S. dollars) to acquire the virtual currency, including fees, commissions and other acquisition costs.

Your gain or loss may be short-term or long-term, depending on whether you’ve held the cryptocurrency for more than one year. Keep in mind that if you sell cryptocurrency at a loss, you’re subject to the same deduction limits as other capital losses.

Purchases of goods or services

Perhaps the biggest tax surprise involving cryptocurrency is that using it to purchase goods or services can trigger a capital gain or loss. That’s because, unlike a purchase using traditional currency, a cryptocurrency transaction is treated as an exchange of one property for another. Your gain or loss is the difference between the fair market value (FMV) of the goods or services you acquire and your adjusted basis in the cryptocurrency you use to make the purchase.

Suppose, for example, that you own 10 Bitcoin that you purchased in 2018 for $5,000 each, for a total of $50,000. In 2021, on a date when the FMV of one Bitcoin had skyrocketed to $50,000, you used four Bitcoin to buy a Tesla Roadster with an FMV of $200,000. Assuming your adjusted basis in the Bitcoin is $5,000 each, your purchase generates $180,000 in long-term capital gain ($200,000 – $20,000).

From the perspective of the seller or service provider, payments made in cryptocurrency must be reported as income, based on the FMV of the cryptocurrency when the payments are received.

Payments to employees or contractors

Just like traditional currency, cryptocurrency may be used to pay employees’ wages or to pay independent contractors for their services. The company must track the cryptocurrency’s FMV as it’s paid and then report the cumulative FMV for the tax year on Forms W-2 or 1099.

Likewise, the recipient must report the cryptocurrency payment as income, based on its FMV when it’s paid. The usual rules apply regarding income tax withholding, payroll taxes and self-employment taxes.

A company also may have a taxable gain or loss due to appreciation or decline in the FMV of the cryptocurrency during the time it was held before it was paid to the employee or independent contractor. Assuming the company isn’t in the trade or business of buying and selling virtual currencies, the gain and loss will be a capital gain or capital loss (short-term or long-term depending on how long it was held).

Digital ledger events

Even if you don’t conduct any transactions using cryptocurrency, certain events on the blockchain or other digital ledger may generate taxable gain. IRS guidance describes two such events:

1. A “hard fork,” which essentially means that a single cryptocurrency is split into two, and
2. An “airdrop,” which may or may not follow a hard fork, is “a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses” — in other words, the developer of the new cryptocurrency drops “free coins” into owners’ digital wallets.

According to IRS guidance, a hard fork by itself doesn’t trigger taxable income. But if the new cryptocurrency is airdropped or otherwise transferred to owners’ accounts, and owners have the ability to immediately dispose of the new cryptocurrency, then they must recognize it as ordinary income.

Documentation is critical

Because the value of cryptocurrency fluctuates widely and frequently, it’s critical to maintain records that show the dates and prices of all your cryptocurrency purchases and sales. You should also keep thorough records of any transactions involving cryptocurrency, such as purchases or sales of goods or services, including the cryptocurrency’s FMV on the dates that payments are received.

If you purchase cryptocurrency on different dates for different prices, it may be possible to specifically identify the units you’re selling or otherwise disposing of. This provides an opportunity to minimize capital gains by selecting the units with the highest adjusted basis. If you don’t (or can’t) specifically identify the units, then you must use the first-in, first-out method — in other words, you’re presumed to dispose of the oldest units, which may increase your tax liability.