Cryptocurrencies from a Tax Perspective – Understanding Taxation for Digital Currencies

by Houston Holmes, Porter Keadle Moore

While cryptocurrency’s role in traditional banking is still being defined, the reality is that consumers are choosing to invest in it. And, because banks desire to be consumers’ primary partner in all money-related activities, increased market adoption of cryptocurrencies will eventually impact financial institutions in one way or another. Regardless of how banks feel about the issue, it is in their best interest to not only understand these currencies, but also the potential legal implications that surround them.

At its most basic level, cryptocurrency is a form of digital currency that can be used to pay for or exchanged for goods and services. The name comes from the fact that the currency uses cryptography for its security, which makes it very difficult to manipulate or counterfeit. Any transaction involving cryptocurrencies takes place entirely in the virtual world with each unit typically having a specific coded address that is stored in a user’s virtual wallet. Similar to some arcades and casinos, the idea has also been used by certain businesses to create their own version of currencies, in the form of tokens or store points that can only be used within that business. And, while cryptocurrencies are not currently backed by any government or financial institution, and no business owner or person is required to accept them, more and more businesses are beginning to do just that.

As one might expect, the IRS has been paying particularly close attention to cryptocurrencies, as well as individuals profiting from those investments, and is now actively taking steps to ensure it gets its share of the taxes from any capital gains. As banks become more involved with cryptocurrencies either directly or through their customers, it is a good idea to know how the government views them, and more importantly, how it plans to tax them.

The subject of taxation and cryptocurrencies is still being defined, but the IRS has provided some guidance on the subject in the form Notice 2014-21. Basically, this states that since cryptocurrency is not legal tender in any recognized jurisdiction, it should be considered property when it comes to federal taxes. This means that any transaction that involves cryptocurrency is taxable. When it comes to any gains, the length of time someone holds the currency could be what determines the tax rate on them. For example, if a cryptocurrency is held for more than a year, then any profits would typically be seen as long-term capital gains (LTCG). However, if it is held for one year or less, the profits would be viewed as short-term gains and thus, taxed at the currency owner’s standard income tax rate (which is typically higher than the rate for long-term). For context, the LTCG tax rate is 0 percent, 15 percent, or 20 percent (plus a possible 3.8 percent) depending the owner’s total income. 

In addition to the difficulty understanding the applicable tax rate, determining the owner’s tax basis can prove to be a moving target, as well. Typically, the holder’s basis is based on the fair market value (FMV) on the date the cryptocurrency is received. To find the FMV for tax purposes means determining how it compared to the U.S. dollar (as quoted in a cryptocurrency exchange) but only if that exchange rate has been established by prior market supply and demand. The receipt of cryptocurrency in exchange for goods and services is a taxable event with the amount realized being the U.S. dollar value of the currency received. If obtained through mining (basically using computing power to solve computationally difficult puzzles in exchange for newly released cryptocurrency and/or transaction fees), the basis would be the FMV on the day the cryptocurrency was received.  Additionally, if mined, the FMV as of the day earned should be included in the gross income of the taxpayer as the miner has exchanged services for the cryptocurrency (self-employment tax may also be due if in the business of mining).  The disposition of bitcoin is also a taxable event with the gain or loss being determined by change in value (compared to the U.S. dollar) between the date of acquisition and the date of disposal. 

When it comes to cryptocurrencies, tracking basis is just as important as it is difficult. Due to their nature, these currencies and their exchanges continue to be volatile and unpredictable, with gains and losses often seeing large daily shifts. While the IRS has been mum when it comes to what inventory method to use, there are several possible options available, such as first-in, first-out (FIFO), last-in, first-out (LIFO) and average cost. The general opinion is that any of these methods should be available for non-security property  (i.e. cryptocurrency), and being that there really is no direct authority currently supporting or advocating a specific position, it is probably best to use the method most beneficial to the individual. Also, bear in mind that while it may not be easy for the IRS to track or identify these transactions, a majority of cryptocurrencies transact on blockchain technology which typically means there is a public (and permanent) ledger of every transaction ever made. 

As the popularity of cryptocurrency continues to grow with consumers, so too will its appeal to businesses, including the banking industry itself. As this happens, it is only a matter of time before regulations also increase to keep pace. Understanding the tax consequences of owning and using cryptocurrency will allow banks the possibility to share that growth and continue to be a strong partner for their customers.

Houston Holmes is a CPA and Senior Tax Manager at PKM, an Atlanta-based accounting and advisory firm serving public and private organizations in the financial services, insurance and technology industries.