Do You Know Your Tax Obligations When it Comes to Virtual Currency?
Jan 27, 2020
As many as 1 in 10 American adults own virtual currency, according to an April 2019 study conducted by Blockchain Capital. But how many of them know what their tax obligations are when it comes to these assets? And is the current tax treatment of virtual currencies even sustainable? The IRS is increasingly taking steps to educate taxpayers and enforce compliance in this area, while lobbyists from the virtual currency industry are attempting to shape relevant tax policies.
The Internal Revenue Service (IRS) defines virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Virtual currencies, such as Bitcoin and its competitors, are typically issued and controlled by their developers or founding organizations. Cryptocurrency, or crypto for short, is a type of virtual currency which uses cryptography to create units of currency and secure transactions via a distributed ledger, such as blockchain.
Because virtual currencies are unregulated and not considered legal tender, they are not treated as currencies for tax purposes in the United States. The IRS considers virtual currency to be property, as described in Notice 2014-21 and Revenue Ruling 2019-24. As such, virtual currency transactions are subject to capital gains tax, which is assessed on the profits of a sale of an asset. Short-term capital gains, or profits earned from the sale of an asset owned for one year or less, are typically taxed at a higher rate than long-term gains, or those made from the sale of an asset held for longer than a year.
Many taxpayers who buy and sell virtual currency are unaware of these tax obligations. Other more common sources of capital gains, such as stock market investments, are subject to information return reporting, typically using the Form 1099 series. Individuals who buy and sell stocks, for example, receive these forms from their financial institutions so they can report the capital gain (or loss) from each sale. The forms are also shared with the IRS and compared with the information reported by taxpayers on their returns.
This reporting is not mandated for virtual currency transactions, however, so only a handful of virtual currency platforms currently issue information returns. It is incumbent on the taxpayer to be aware of this requirement and to self-report transactions to determine the tax owed. At a Tax Policy Center event in October 2019, Chief Counsel of the IRS Michael Desmond stated that the IRS is in the nascent stages of establishing information reporting requirements for virtual currency transactions, which they believe will have a significant impact on compliance.
As with other tax compliance issues, the IRS is using a two-pronged approach toward increasing compliance in this area. First, the agency is attempting to inform taxpayers about their obligations before they file their tax returns. This largely comes in the form of news releases and informational content on the IRS.gov website, as well as direct guidance provided to taxpayers by IRS employees. In addition, a checkbox for virtual currency transactions was added to the 2019 Form 1040 Schedule 1 to encourage voluntary compliance, based on the success of a similar checkbox for offshore financial accounts added to Schedule B in 2013.
Second, the IRS has been taking enforcement action after filing to resolve improper or lack of reporting. According to Mr. Desmond, the IRS issued over 10,000 notices in 2019 to taxpayers regarding issues around virtual currency. Even without mandated information reporting, the IRS has access to information from virtual currency platforms that allows them to identify taxpayers who have not reported. In addition, Mr. Desmond related that some unreported transactions have been discovered through the course of routine audits. The agency is working with taxpayers who attempted to report in good faith and is providing guidance toward proper filings. Enforcement actions, at this time, are primarily being focused on taxpayers who did not report gains from virtual currency transactions at all.
Those in the crypto industry have objected to the current tax treatment of virtual currencies, which they view as untenable. Although many owners of crypto approach it as a novelty or hobby and tend to retain these assets, crypto industry insiders see a future in which crypto will be used for everyday transactions, much like real currency. In that scenario, tracking and reporting each transaction’s gains or losses could be burdensome.
Other factors that might complicate the application of the tax principles governing property to crypto in this context include:
- Increase in frequency of transactions. If the future of crypto envisioned by its proponents is realized and consumers begin using it for everyday transactions, the sheer number of transactions would make it extraordinarily complicated to compute the tax owed under the tax principles governing property, with or without information reporting.
- Rapidly fluctuating value. The value of crypto tends to fluctuate rapidly, even in the time it takes to remit a payment. This makes it challenging to compute the gain or loss when it comes to frequent transactions, as the cost basis, as well as market value at the time of the sale, must be known.
- Emergence of micropayments. Because conducting a transaction using blockchain has no associated costs, the crypto industry sees a future for micropayments that isn’t currently possible with traditional currency and electronic payment methods due to processing fees. For example, instead of paying a subscription fee to a paywalled online publication, a user might be able to pay the equivalent of 1 or 2 cents to access a single article. Computing the gain or loss on many of these tiny payments would become impractical for the average taxpayer.
So, what kind of policy changes do lobbyists working on behalf of actors in the crypto and blockchain industry advocate? The Blockchain Association neatly distills these tax policy positions into two main points:
- Establish reporting requirements for virtual currency transactions. Mandated reporting for virtual currency transactions would lift the burden off the taxpayer to determine their own tax liability, improving the overall accuracy of reported gains from transactions and increasing compliance with tax regulations.
- Expand the de minimis exemption to include virtual currencies. The de minimis rule refers to the exemption of gains less than or equal to $200 earned through personal transactions using foreign currency from taxation. Crypto advocates are urging the US government to extend this exemption to virtual currency transactions, rather than treating them as non-exempt property transactions, to eliminate the legal obligation to report gains or losses on frequent, small payments.
It seems there are no anticipated changes to the tax treatment of virtual currencies in the immediate future, but pro-crypto lobbyists continue to put pressure on Congress, the Treasury Department, and the IRS. Although the IRS is in the early stages of establishing reporting requirements for virtual currency transactions, it stands behind its guidance and rulings, maintaining that the IRS does not have a role in shaping policy. While the Treasury does influence policy, it will ultimately fall to Congress to determine whether virtual currency tax law should change.