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How does the IRS treat cryptocurrency?
Cryptocurrency is considered property, but when traded it is treated similar to stock. Anytime cryptocurrency is converted to cash or a different cryptocurrency, it is a taxable event.
What happens if you lose your cryptocurrency?
Since cryptocurrency is treated as property, if you lose access to your wallet or if your cryptocurrency is lost or stolen, you can’t get a deduction on your tax return due to the Casualty or Theft Loss rules under the 2017 Tax Cuts and Jobs Act (“The Act”). Under this Act, an individual’s personal casualty and theft losses generally are deductible only to the extent that they are attributable to a federally declared disaster. Personal casualty losses that are not attributable to a federally declared disaster can be deducted, but only to the extent that the individual has personal casualty gains.
What happens if I sell my cryptocurrency?
Cryptocurrency is treated similar to publicly traded securities in that you will recognize a gain or loss based on your basis, selling price, and holding period.
What happens if I swapped one cryptocurrency for another?
This is a taxable event. You will recognize a gain or loss equal to the difference between the acquisition price and the specific asset price on the date of the swap.
Cryptocurrency does not qualify for like-kind exchange treatment.
What happens if I bought goods or services using cryptocurrency?
This is a taxable event. You will recognize a gain or loss equal to the difference between the acquisition price and the specific asset price on the date of the purchase. For example, if you bought $8,000 worth of Bitcoin and the value increased to $80,000, you have an unrealized gain that is not taxable as long as the Bitcoin remains in your digital wallet (similar to holding stock in a brokerage account.) Now, if you then decide that you want to purchase a Tesla with your $80,000 worth of bitcoin, the conversion of Bitcoin to the Tesla transaction results in a $72,000 capital gain.
What is a blockchain fork?
Forks are certainly beyond the scope of this article, but we will do our best to explain in simple terms what these transactions are and how they can impact your taxes. Simply put, “Forks” are software updates that can cause a split in the blockchain network. Clear as mud, right? To add further confusion to the mix, there are different types of “forks:” soft and hard.
Soft vs. Hard Forks
A “soft fork” is an IT update to the blockchain network. No new coins are created from this event. A “hard fork” occurs when the IT update creates an entire new blockchain ledger. This essentially creates new coins on a new blockchain from the old blockchain. The most well-known “hard fork” example occurred in 2017 with Bitcoin Cash (BCH) being created from Bitcoin (BTC). Users received the same amount of Bitcoin Cash (BCH) as they held in their original wallet of Bitcoin. The reason for the Bitcoin “hard fork” was a disagreement among users of Bitcoin about its future purpose. Forks can occur for a number of reasons and there could be tax implications.
Why are Hard Forks important?
In the event of a Hard Fork and the creation of new coins, any additional coins received beyond your initial holdings could be considered taxable.
What is a “Wash Sale” ?
No, this is not referring to your neighborhood car wash fundraiser, we are talking about the sale of a security at a loss and repurchasing the same or substantially identical security within 30 days. “Wash Sales” are governed by §1091 of the Internal Revenue Code and the rules are straightforward when it comes to securities. This issue has gained a head of steam with the rise of cryptocurrencies. The intent behind the wash sale rules is to prevent investors from recognizing “artificial losses” in instances where the investor does not intend to decrease their holdings in the securities that were sold. Per IRS Publication 550: Investment Income and Expenses, a “wash sale” occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys a “substantially identical” stock or security or purchases an option contract to do so.
Wash Sale Example (Stock):
01-01-2021: Purchase 10 Shares of Microsoft @ $250: ($2,500) Cost Basis
01-31-2021: Sells 10 Shares of Microsoft @ $240: $2,400 Fair Market Value
Realized Loss at time of sale: ($100)
02-15-2021: Purchase 10 Shares of Microsoft @ $245: ($2,450)
Add Back Wash Sale Loss Disallowed to Cost Basis: ($100)
Cost Basis of Stock Purchased on 02-15-2021: $2,550
The $100 loss from the first transaction will be a non-deductible wash sale due to the acquisition of the same stock in less than 30 days from realizing a loss.
Does the Wash Sale concept apply to cryptocurrency?
When dealing with cryptocurrencies and whether the “Wash Sale” rules apply, we must first consider the term “securities”, as defined by §1236(c) of the Internal Revenue Code. Per §1236(c), the term “security” means any share of stock in any corporation, certificate of stock or interest in any corporation, note, bond, debenture, or evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing. Based on this definition, one could make the argument that cryptocurrencies are not considered “Securities” for purposes of the “wash sale” rules. However, there are different opinions among a number of sources.
The Securities & Exchange Commission (“SEC”) issued a report in 2017 finding that DAO tokens, a type of cryptocurrency, should be considered “Securities” under the Securities Act of 1933 (“Securities Act”), which would lend itself to go against the definition of a security per §1236(c) mentioned in the previous paragraph. Meanwhile, the IRS defines virtual currency as “property” per Notice 2014-21. The jury is still out on whether “wash sale” rules apply to cryptocurrencies. One thing that is certain is that the IRS will continue to crack down on unreported cryptocurrency income and having trusted advisors is critical to remain in compliance with an ever changing tax landscape.
Will the exchange provide me with a 1099 to show my activities?
The majority of the exchanges will not provide you with a 1099. Rather, they will just provide you with a list of the transactions and you will have to figure out your gains and losses. Why?
It is extremely time consuming to list out all of the transactions and exchanges on a 1099 (Coinbase does do this). Many of the exchange websites do not have the personnel and are unwilling to invest in a department that could handle this reporting for their customers. The exchanges are not currently required by law to provide their customers with tax reporting information in the way that traditional banks are required to report information about traditional securities investments.
Texas Cryptocurrency Law knocks on Gov. Abbott’s Door
On May 31st, House Bill HB4474 was passed by the senate and sent to Texas Governor Gregg Abbott for his signature. The newly passed bill recognizes Bitcoin and other digital assets under the state’s commercial laws. The approval of the new Bill will play a crucial role in helping Texas become a crypto hub, given it is already quite popular among Bitcoin mining companies such as Riot Blockchain and BlockCap.
Oh my, Ahmed, that is a lot of information, what do you recommend?
Cryptocurrency is still in its infancy and it has fascinating technology that has the potential to change how we look at money. Will it be the next Netflix or the next Blockbuster, no one knows! One thing for certain is that the tax consequences are evolving every day and the IRS will issue further regulations to ensure that you pay your fair share of taxes.
I recommend that investors keep track of their purchase price or cost basis, date of purchase, and the value of any coins received. The majority of people who invest in cryptocurrency do not purchase a whole coin but rather a fraction of coin, which is why it is so important to keep track of the items we list above to help ease the burden when it comes to reporting these transactions on your tax return. My advice is to keep track of your records and remember that the exchanges that tell you that you can buy and sell a thousand times a day are creating a huge tax compliance nightmare. There are many other facets and extensions to cryptocurrency including DEFI (“Decentralized Finance”) which we will discuss in a future blog.
Contact your friendly crypto experts at HM&M to discuss your crypto tax compliance needs!
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