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United States Crytocurrency Transaction Tax Rules
Whether you’re an investor expanding your portfolio to include digital assets such as cryptocurrencies and tokens, a business that uses cryptocurrencies to engage in everyday transactions, or a crypto “miner,” you need to keep in mind the tax implications of your activities. The purpose of this article is to provide you with a brief primer about the U.S. federal income tax implications of transactions involving cryptocurrency and similar digital assets.
Crypto is Treated as Property
Buying and Selling Crypto for Cash
Let’s start with the basics. Whether on your own or indirectly through a broker, let’s assume you’ve done some preliminary research, opened up a digital wallet, funded your account with cash, and you’re ready to purchase one of the many types of digital assets available to you.
Buying cryptocurrency with cash is not a taxable event and is generally treated the same as if you purchased a widget or other type of property (e.g., stocks or bonds) for cash. In fact, the similarity of cryptocurrency and property is important and you should keep that in mind throughout this article because, for income tax purposes, the IRS treats cryptocurrency the same as it treats property (the “Property Rule“).1 For example, when you purchase cryptocurrency (or any property) for cash, your tax basis in the cryptocurrency (or property) acquired is the amount of cash you paid.
Consistent with the Property Rule, selling cryptocurrency for cash is a taxable event and is generally treated the same as if you sold a widget or other type of property for cash. Just like any other sale of property, you calculate your gain or loss as the difference between (i) the amount of cash received in the sale and (ii) your tax basis in the property sold.
Example #1: Assume A, an individual, purchases cryptocurrency (CRYPT) for $100 in cash. As a result, A’s tax basis in CRYPT is $100. Later, A sells CRYPT for $110 in cash. As a result, A’s gain is $10 (i.e., $110 sales price, less $100 tax basis).
Whether that $10 of gain is treated as ordinary income, short-term capital gain, or long-term capital gain depends upon A’s particular facts and circumstances. For example, if the CRYPT was purchased and held as an investment (e.g., a capital asset), then gain from its sale would be capital gain – subject to long-term capital gains rates (e.g., 20%) if it was held for at least a year, or short-term capital gains rates (which are currently the same as ordinary income tax rates) if it was held for less than a year. If, alternatively, the CRYPT was not held as a capital asset, for personal use, or as an asset used in a trade or business, but was instead held as inventory, then the gain from its sale would be subject to ordinary income tax rates.
Using Cryptocurrency to Buy Another Cryptocurrency/Digital Asset is Taxable
Buying Property with Crypto
Example #2: Assume A purchases CRYPT for $100 in cash and, as a result, has a $100 tax basis in CRYPT. Later, A desires to purchase other property (PROPERTY) that has a fair market value of $110. A transfers CRYPT in exchange for A’s acquisition of PROPERTY. As a result, A’s gain is $10 (i.e., $110 value of the PROPERTY received, less $100 tax basis in the CRYPT transferred).
Example #2 is similar to Example #1, with the only difference being that instead of A receiving $110 in cash, A receives $110 in the form of PROPERTY. Nevertheless, A’s gain in Example #2 is exactly the same as A’s gain in Example #1. Worth noting is that A’s basis in PROPERTY is $110 – calculated as the sum of (i) A’s $100 basis in CRYPT, plus (ii) the $10 gain that A recognizes in Example #2.
Viewed in this light, and keeping in mind the Property Rule, you can see how, for A, any barter exchange is actually both (i) a sale (e.g., by A of CRYPT), and (ii) an acquisition (e.g., by A of PROPERTY). And this principal applies whenever you use cryptocurrency to purchase any goods (or, as discussed below, services). The critical point to keep in mind is this: if your cryptocurrency increases in value between the time you first obtain it and the time you use it to acquire something with it (whether goods or services), then you will have gain on the acquisition – measured by your tax basis in the cryptocurrency transferred, and the value of what you received in exchange for that cryptocurrency. Although many people expect to owe taxes when they sell something, as the use of cryptocurrencies becomes more mainstream there is a concern that many people will be surprised to learn that they may owe taxes when they use their cryptocurrency to purchase other goods or services.
The Property Rule described above has significant implications for investors and traders in digital assets because any exchange of one type of digital asset for another digital asset can be a fully taxable event. For example, if you own Crypto-A, worth $110, and exchange that for Crypto-B, also worth $110, then this exchange is treated the same as the barter transaction illustrated in Example #2. When applying the Property Rule to this transaction, the result is not at all surprising. That is, when you transfer Crypto-A in exchange for the receipt of Crypto-B (worth $110), then you have income or gain to the extent your tax basis in the Crypto-A transferred is less than the fair market value of the Crypto-B received. And for those investors who use cryptocurrency to purchase Non-Fungible Tokens (“NFTs”), the Property Rule similarly applies with the same results.
Buying and Selling Services Using Crypto
Paying for Services with Crypto
Cryptocurrencies can be used to pay for services, or received in exchange for the performance of services. Both are explored in greater detail below – and both are subject to the Property Rule.
Example #3: Assume A purchases CRYPT for $100 in cash and, as a result, has a $100 tax basis in CRYPT. Later, A desires to pay B for the performance of services (SERVICES) (e.g., house painting), and the cost of those services is $110. Pursuant to the Property Rule, when A transfers CRYPT to B for B’s performance of SERVICES, A has $10 of taxable gain (i.e., $110 value of services received, less $100 tax basis in CRYPT paid).
When businesses are involved, things start to get interesting. Assume A is not an individual, but is instead a business – e.g., A, Inc., and assume further that the payment by A, Inc. of $110 to B gives rise to an ordinary and necessary business deduction for A, Inc. (e.g., for consulting services, software development, etc.). In such a case, A, Inc. has both (i) $10 of income or gain (as illustrated in Example #3), and (ii) a $110 deduction. If B is an independent contractor, then the payment must be reported on an IRS Form 1099 based upon the fair market value of the cryptocurrency at the time of payment.
Another iteration of Example #3 arises when the payment by A, Inc. is to an employee and is therefore subject to employment and payroll tax withholdings. In such a case A, Inc. should be careful to ensure that the aggregate payment is bifurcated between (i) the portion that can be paid directly to B in cryptocurrency, and (ii) the portion that needs to be remitted to the applicable governmental authorities in cash. And, as above, the entire payment must be reported on an IRS Form W-2, based upon the fair market value of the cryptocurrency at the time of payment.
Being Paid in Crypto for the Sale of Goods or Performance of Services
Until now, this article has focused on the tax treatment of the party using cryptocurrency to pay for goods and services. As one would expect, the payee also needs to be aware of its own tax treatment. Whether selling goods or performing services, the payee/recipient of cryptocurrency recognizes income or gain in an amount equal to the fair market value of the cryptocurrency paid. And, as above, the character of that income or gain depends on the facts and circumstances particular to the payee. If the payee is selling inventory or performing services, then the payee would recognize ordinary income; and if the payee is selling personal-use property, a capital asset, or property used in a trade or business, then the payee may have capital gain or loss.
Other Crypto-related Transactions
Other transactions resulting in the receipt of cryptocurrency will generally be subject to income tax to the recipient. For example, cryptocurrency received from mining, forging, or staking (e.g., as a reward, a share of commissions, or as a transaction fee) would generate ordinary income in an amount equal to the fair market value of the cryptocurrency mined or received, which income would generally be subject to income and self-employment taxes. Furthermore, receiving cryptocurrency by “airdrop” (e.g., as a marketing giveaway by a business or a new token project) would also give rise to ordinary income. In each of these situations, a taxpayer should include as ordinary income the fair market value of the cryptocurrency received. And, in each instance, the amount included as taxable ordinary income is then added to the taxpayer’s basis of cryptocurrency received, thereby ensuring that the taxpayer does not pay tax on the same amount both at the time of receipt and again at the time of disposition.
Gifts of cryptocurrency, whether to family members or charitable organizations, are becoming more common and in those instances the Property Rule continues to be a helpful reference. Generally, the contribution of a long-term capital gain asset (e.g., cryptocurrency held for more than a year as an investment) will give rise to a charitable deduction in an amount equal to the fair market value of the asset at the time of donation. In other situations, the amount of the charitable deduction may be limited to the donor’s tax basis in the asset donated. Although easily and widely traded, many cryptocurrencies do not currently fit within the definition of a “publicly traded security.” In the context of charitable donations, this means that (i) in order to take a charitable deduction of more than $500 the donor will need to comply with various recordkeeping and substantiation requirements, and (ii) donations of more than $5,000 may require a qualified appraisal.
Reporting, Record Keeping, and Losses
In light of the above, it is critical for taxpayers to maintain adequate records relating to the value of their cryptocurrencies at the time of receipt and disposition – which information, in turn, allows taxpayers to calculate their tax basis, amount realized, and resulting tax consequences.
While we have largely focused on income and gain, it is quite possible to dispose of cryptocurrency after it has decreased in value – thereby giving rise to a loss. The ability to use capital losses are complex, but generally speaking, short-term capital losses can offset short-term capital gains (whether from cryptocurrency transactions or otherwise) and long-term capital losses can offset long-term capital gains.2 And unused losses may be carried forward to subsequent years. Some cryptocurrency platforms may generate information returns (e.g., IRS Form 1099-B) with information intended to help taxpayers calculate their gains and losses in a given year.
When a taxpayer purchases the same cryptocurrency in tranches, at different prices, over time, and later disposes of that cryptocurrency, a question arises as to which cryptocurrency is being sold – the answer to which will determine the taxpayer’s tax treatment on the sale.
Example #4: Assume A purchases (i) one “cryptocoin” on January 1, Year 1 for $100, and (ii) one cryptocoin on January 1, Year 2 for $600. Assume further that on June 1, Year 2, A sells one cryptocoin for $300.
If A had the ability to cherry-pick which cryptocoin it sold and A reported the transaction as a sale of the cryptocoin purchased in Year 1, then A would recognize a $200 long-term capital gain (i.e., $300 – $100); but if A reported the transaction as a sale of the cryptocoin purchased in Year 2, then A would recognize a $300 short-term capital loss (i.e., $300 – $600).
Although a taxpayer may want to cherry-pick to control the tax implications of its sale, unless the taxpayer is able to specifically identify which cryptocurrency it is selling, it would be prudent for the taxpayer to follow the IRS’ first-in, first-out method of accounting generally applicable to the sale of stocks.3 If a taxpayer is able to distinguish between the cryptocurrencies held (e.g., Bitcoin vs. Ethereum; or if the taxpayer held the same cryptocurrency in different digital wallets), then the taxpayer may be able to specifically identify which cryptocurrencies it was selling. The burden of proper reporting and recordkeeping can be heavy, but a growing number of vendors are deploying software service products to assist traders and investors in generating the necessary reporting and record keeping information.
Tax Rules are in Flux | Stay on Top of It
Cryptocurrencies, NFTs, and other digital assets are highly volatile, comparatively speculative, and, for many, difficult to understand. As the industry is still young, with many questions unanswered and some having yet to be asked, tax authorities will continue to publish guidance clarifying the tax implications of these transactions, and taxpayers, undoubtedly, will do their best to comply.
Most recently, in an effort to encourage global tax transparency relating to cryptocurrency transactions, the Organisation for Economic Co-operation and Development (OECD) released a framework for the reporting and exchanging of information within and among countries around the world relating to cryptocurrency transactions and their tax treatment. And, with a similar goal in mind, President Biden recently released an Executive Order requesting a report from the Secretary of the Treasury addressing the future of digital assets and its implications on the U.S. financial system.4
Regardless of whether the cryptocurrency and related digital asset markets are temporary and fleeting, or here to stay, the rules relating to the taxation of transactions involving these assets cannot be ignored.
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Footnotes
3. Treas. Reg. Sec. 1.1012-1(c)(1).
4. “Ensuring Responsible Development of Digital Assets”, Executive Order (March 9, 2022).
