There has been a steep rise in the price and use of cryptocurrency or virtual currency, such as bitcoin, and advisors and their clients may have questions about the tax implications.
Bitcoin and other cryptocurrencies have been around for almost a decade and can be traded digitally on the internet, exchanged into U.S. dollars, and used to buy goods and services.
Virtual currency can be a source of investment and speculation. Using digital currency for purchases of goods and services where accepted carries the following benefits: it is cheaper than using credit cards; it is conducive for use in the global economy; it is easier and safer than paying with cash; and it is not subject to inflation.
Legal tender is accepted and used as a medium of exchange and is used as payment for goods and services in the country of issuance but not typically outside the jurisdiction. Depending on the environment, virtual currency can be treated like real currency (coin and paper money in the United States) and accepted as a means of payment.
However, virtual currency doesn’t have legal tender status in any jurisdiction.
Virtual currency is typically listed on an exchange with the price established by market supply and demand conditions. The fair market value of the virtual currency on any given date is determined by converting it into U.S. dollars at the exchange rate.
For federal tax purposes, virtual currency is treated as property and not currency. The fair market value of the virtual currency on the date of receipt determines the taxpayer’s basis.
Here are some other points to keep in mind:
- If you receive virtual currency as payment for goods and services, the fair market value of the virtual currency is included in taxable income
- Payments made to independent contractors for services provided using virtual currency are subject to income tax and self-employment tax and reported on Form 1099. The fair market value of the virtual currency establishes the taxable amount.
- The character of the gain or loss from the exchange or sale of virtual currency will depend on whether the digital currency is a capital asset, such as stocks and bonds, or is held as property for resale to customers (inventory item).
- Virtual currency can be acquired through a mining process by using complex, encrypted mathematical equations. If you mine virtual currency, the fair market value of digital currency at the date of receipt is included in gross income.
- Wages paid to employees in virtual currency instead of in U.S. dollars are taxable to the employee and must be reported on Form W-2. The employee is taxed at the fair market value of the digital currency.
Some tax law specialists and virtual currency traders have treated the exchange of one virtual currency for another as a like-kind exchange of property. This treatment defers any gain realized on the transaction until you ultimately exit the cryptocurrency market altogether.
However, under the tax reform law and effective beginning in tax year 2018, like-kind exchange treatment can no longer be claimed for exchanges of personal property but can only be claimed for exchanges of real property. Thus, investors are no longer able to defer taxes when they exchange one virtual currency for another at a gain on the price appreciation.
Instead, the investor must recognize a capital gain on the appreciation once the transaction is completed.
Advisors should set themselves apart from the competition by continuing to learn about new developments in emerging technology and by becoming a domain expert in this fascinating space.
