Virtual Currency: Basic Concepts and Taxation Essentials

Virtual currencies represent an innovation in financial services, products and technology that has the potential to support a more efficient and transparent global commerce by proposing lower transaction costs and rapid availability of cash.

In spite of the aforementioned benefits, before engaging in virtual currency transactions, investors should have a clear understanding of what they are, how they can be utilized and what are some of the tax ramifications to U.S. taxpayers. This article addresses a few of the basic concepts of virtual currencies, such as blockchain and mining, as well as how the Internal Revenue Service (IRS) treats the most common virtual currency transactions.

What is virtual currency?

As defined by the IRS (2021), virtual currency is “a digital representation of value that functions as a medium of exchange, a unit of account, and/or store of value” [1]. In other words, it represents a monetary value that can be bought, sold or exchanged into “real money”. However, in some environments, it operates similar to “real” money, having an equivalent value in real currency but not backed by a central bank. When this is the case, it can be referred to as “convertible” virtual currency. The famed Bitcoin (BTC) is one example of a convertible virtual currency along with Ethereum (ETH), Litecoin (LTC), Cardano (ADA) and more than 4,000 others in existence as of January 2021.

It is also important to make a distinction between crypto currency and virtual currency. Crypto currency is a type of virtual currency that utilizes cryptography to validate and secure transactions that are digitally recorded on a decentralized ledger for added anonymity and protection.

Defining Blockchain

Commonly defined as a distributed list/database of all crypto currency transactions across a peer-to-peer network, the blockchain concept was originally introduced in 2008. A blockchain is decentralized, which means that no single user or group has control. Rather, all users collectively control it. It is also considered to be “authoritative” because every user agrees on it. Different types of information can be stored on a blockchain but the most common use so far has been as a ledger for crypto currency transactions.

These virtual ledgers are “mined”, meaning that they are maintained and serviced in order to verify the legitimacy of the transactions.

Understanding “Mining”

Mining is the act of maintaining, validating and auditing crypto currency transaction blocks which are then added to the blockchain.

Subsequently, “miners” are the people who maintain the blockchain and invest in the specialized computer hardware needed to rapidly process complex computations. They can be awarded in crypto currency in exchange for verifying each transaction and adding it to the blockchain. Miners are often referred to as the blockchain “auditors”. Nowadays, mining has become much more competitive prompting miners to come together in groups, combine their computer power and split the mined virtual currency between the participants, hence creating “mining pools”. These pools alongside mining companies represent a large percentage of the overall virtual currency computing power.

Uses of Virtual Currencies

The virtual currency engine can be complex but the uses are very straight forward. The most common ones are as a capital asset, as a form of payment for goods and services, to make charitable contributions or gifting in general, and to receive as form of payment for services rendered.

Even though virtual currencies are considered to be highly unregulated, the IRS has issued guidance on taxation for U.S. taxpayers depending on how it is used and the type of transactions being made.

How does the Internal Revenue Service treat the most common virtual currency transactions?

The IRS first introduced guidance on the tax treatment of virtual currencies in 2014 (See IRS Notice 2014-21) and four years later in 2018 announced the Virtual Currency Compliance Campaign [2] to address noncompliance through outreach and examination of taxpayers. Furthermore, in 2019 a virtual currency checkbox (asking the taxpayer if at any time during the tax year, they received, sold, sent, exchanged, or otherwise acquire any financial interest in any virtual currency) was added at the top of Schedule 1 of Form 1040 (Individual Income Tax Return Form) and in 2020, it was moved to the first page of Form 1040 with instructions providing additional guidance about virtual currency transactions.

The IRS considers virtual currency as a capital asset, similar to owning stock. It is not treated as currency, like U.S. Dollars or Euros. When it is acquired, it has to be reported by marking YES on Form 1040, the sale must be reported on Schedule D of Form 8949 (Sales and Dispositions of Other Capital Assets) and it is subject to any limitations on the deductibility of capital losses.

Virtual currency as a capital asset: basis, sales and dispositions

The cost basis of virtual currency is the amount spent to acquire the asset, including fees, commissions and other acquisition costs in U.S. Dollars. The adjusted basis is the cost basis increased by certain deductions or certain credits. If the virtual currency has been held for one year or less before selling or exchanging, the taxpayer will incur in a short-term capital gain or loss. Conversely, if it is held for more than one year before selling or exchanging, then there will be a long-term capital gain or loss. The holding period begins on the day after it is acquired and ends on the day of sale or exchange.

Virtual Currency as payment for goods and/or services: payer vs. payee

If virtual currency is used as a form of payment for goods or services, the payer will recognize a capital gain or loss but the payee will recognize income and would report depending on how it was received: as a profit or loss from a business activity (Schedule C on Form 1040 or 1040-SR), as wages (W-2) or as any other type of earned income (1099, 1099 MISC, etc.), taking into consideration that there may also be backup withholding requirements.

Charitable Contributions in Virtual Currency

Just as with donating stock, the IRS recognizes the use of virtual currency for non-cash charitable contributions. If the total deduction for a virtual currency charitable contribution exceeds USD$500.00 it must be reported by the donor on Form 8243 (Noncash Charitable Contributions Form) and if the deduction exceeds $5,000.00 it must be reported in Section B of Form 8243. In addition, the transaction has to be reported by marking YES on Form 1040.

The charitable contribution deduction will be equal to the fair market value of the virtual currency at the time of the contribution if it has been held by the donor for more than one year. If it were held for one year or less, the deduction would be the lesser of its cost basis or the current fair market value at the time of the contribution.

Taxation on Professional Mining Vs. Mining as a Hobby

Defined by the IRS, a professional virtual currency miner “is someone who is in the trade or business of receiving income from mining cryptocurrency and expects to make a profit”. These individuals would be subject to the IRS guidelines for recipients of virtual currency as remuneration for services provided (See Virtual Currency as Payment for Goods and/or Services Provided section above).

If income from mining activity is received but treated as a hobby and fits the “not-for-profit” rules of IRS Publication 535 on business expenses, it would be reported as “other income” in line 8 of Schedule 1 (Additional Income and Adjustments to Income) of IRS Form 1040.

Other Tax Implications

There are many other transactions that were not listed in this article that are subject to taxation by the IRS like outright gifting, acquiring virtual currency as a result of an exchange of property, among others.

Just as U.S. taxpayers should be aware of taxation regarding virtual currency transactions, there should also be a distinction among the activities the IRS does not consider for tax purposes: transferring virtual currency between two accounts or digital wallets when both are owned by the same taxpayer or holding virtual currency in a digital wallet or account as a capital asset without engaging in the trade or business of selling such virtual currency are not considered taxable events.

Conclusion

Without a doubt, virtual currencies have caused a disruption within three separate, yet interconnected areas: technology, financial capital markets and payment systems. Now that it has become more evident that virtual currencies are here to stay, governing entities are looking at ways to start regulating them. It is the U.S. taxpayer’s discretion to disclose transactions in virtual currencies to the IRS since reporting is not currently required.

Understanding the basic concepts is paramount to successfully taking advantage of the financial opportunities virtual currencies have to offer, as well as to accurately assessing the risks involved. This article explained some of those concepts and taxation guidelines on the most common transactions, however, the scope of virtual currencies is very broad and its taxation heavily depends on the taxpayer’s particular situation. It is recommended to consult a tax professional for advice on all tax ramifications within a virtual currency transaction. For further information on IRS guidelines please visit  IRS FAQ’s on Virtual Currency Transactions. Your wealth advisor at Round Table Wealth Management is available to help with your virtual currency questions.

Sources:

[1] Internal Revenue Service. (2021, April 30). Virtual Currencies. https://www.irs.gov/businesses/small-businesses-self-employed/virtual-currencies

[2] Internal Revenue Service. (2018, July 2). IRS Announces the Identification and Selection of Five Large Business and International Compliance Campaigns. https://www.irs.gov/businesses/irs-lbi-compliance-campaigns-july-2-2018

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By |2021-07-16T13:27:07+00:00July 16th, 2021|Blog|0 Comments

About the Author:

Marianne Rodriguez is a Director, Wealth Advisor at Round Table Wealth Management. Read Marianne's Biography >