What is Cryptocurrency, and How is it Taxed?

By Bonie Montalvo

What is Cryptocurrency, and How is it Taxed?Background on Cryptocurrency

Cryptocurrency is digital “money” used as a medium of exchange in the world market. There are more than 1,500 known virtual currencies, with the most popular being Bitcoin. Bitcoin is a digital token — with no physical backing —not backed by gold or paper bills.

Back in the day, when a cashier received a bill over $100.00 that cashier would use a fancy pen to draw a line across the bill to ensure the bill was real. This same premise is applicable to cryptocurrency. Imagine that you are looking to purchase a digital coin, before you complete the purchase you would need to verify that the coin you are purchasing is “real,” that the coin was not a hoax nor stolen, and that you will have rightful possession of the coin at the completion of your purchase. To address such issue, coins are an authenticated by ledgers, which record all transactions involving that specific coin. Anyone in the world can contribute to a coin’s ledger—even you, if you have a computer handy.

This peer-to-peer network for verifying transactions assures that no “cheating” occurs (i.e. prevents one coin from being sold to multiple buyers). The process of validating transactions is referred to as “mining” and the individuals who maintain the ledgers are referred to as “miners.” Miners, with the help of computers, verify and timestamp cryptocurrency transactions, which validate the cryptocurrency in the digital market. This verification process is referred to as mining, because miners who successfully authenticate a transaction are given cryptocurrency coins as a reward, which is the only way new coins can be added to the system.

No country nor bank controls cryptocurrency, meaning that governments cannot freely issue cryptocurrency (i.e. cannot print free money), and as such, cryptocurrency—in theory—is protected from government manipulation or interreference. Instead cryptocurrency operates in an atmosphere of decentralized control, where the public at large is the overseer of the currency.

Cryptocurrency is becoming more mainstream, with business such as Overstock and Expedia now accepting cryptocurrency as a form of payment. To some, the appeal of cryptocurrency is that it can safeguard from government interference. Cryptocurrency has become widely popular in Venezuela, a country plagued with hyperinflation, providing Venezuelan’s with a medium of exchange that they can trust more than their own national currency. Further, cryptocurrency can protect individuals from government meddling, consider Greece back in 2015, when the Greek government froze access to banks and set limits on how much account holders could withdraw per day. While there are certain benefits of using cryptocurrency over regular currency, the use of cryptocurrency—at least in the United States— requires accurate recordkeeping by the holder of the currency.

Taxation of Cryptocurrency
The Internal Revenue Service has determined that cryptocurrency is an asset, and as such, it is treated as property for tax purposes. General tax principles applicable to property transactions apply to cryptocurrency, and the gain or loss on the sale or exchange of cryptocurrency is taxed as capital gain or loss (ordinary gain or loss if held as inventory) to the taxpayer.

If you bought a bagel from a bakery that accepts cryptocurrency, you’ll need to report that. This means that records must be maintained, transactions must be translated to U.S. dollars, and the cost basis of the cryptocurrency must be tracked. If the value of the cryptocurrency increased, you’re responsible for paying capital gains tax on the difference. If you paid $1 for the cryptocurrency and it is worth $3 at the time you buy your $3 bagel, you have $2 of reportable gain on the transaction.

Gifts of cryptocurrency are also reportable: In that case, you inherit the cost basis of the person who gave it to you. If someone gifts you a digital coin and you use that coin to pay for your bagel, you must (i) track down the transferor’s basis on the coin and (ii) record any gain or loss on the transaction in U.S. dollars.

Further, when a taxpayer successfully mines cryptocurrency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. Aside from reporting their mining “reward” as income, miners will also have to report gain or loss when they dispose of their cryptocurrency. If the cryptocurrency miner is self-employed, his or her gross earnings minus allowable tax deductions are also subject to the self-employment tax.

The IRS places the recordkeeping responsibility on the taxpayer, and taxpayers who do not properly report their virtual currency transactions can be audited and be liable for penalties and interest. In extreme cases, failure to report transactions can result in fines up to $250,000 and even prison.

This Article does not constitute legal advice and may not be relied upon as such. Each individual’s facts and circumstances are different. If you have any questions regarding your particular situation, please consult with legal counsel.

Bonie Montalvo practices in the areas of estate planning, business succession planning, tax planning, and not-for-profit law. Ms. Montalvo has her LL.M. in Taxation from the University of Florida and is fluent in Spanish.

Wood, Buckel & Carmichael Attorneys in Law

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