Digital currencies have had dramatic ups and downs in recent years and especially the last few months. But since Bitcoin was launched in 2009, digital assets have steadily become more popular. Not surprisingly, these new forms of assets give rise to new rules for their regulation and taxation. Yet despite their increasing use as investments and in commerce, the IRS has issued relatively little guidance about taxing virtual currencies and digital activity in general.
The general term “digital asset” is a broad category that includes virtual currencies, pass-through and asset backed tokens, nonfungible tokens (NFT) and other holdings. The IRS has defined 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.”
Reporting Digital Transactions
You may have noticed a question that started appearing on Form 1040 in 2019: “At any time during 2019, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” At first, some wondered if leaving the answer blank could delay processing, the receipt of a refund, or even raise the audit profile of a tax return.
In 2022 the IRS clarified that the mere purchase of virtual currency does not require a “yes” answer. If your only transactions were purchases of virtual currency with real currency, you are not required to answer “yes” to the Form 1040 question. You can check the “no” box. Beyond that, determining what digital assets or transactions you need to report and what transactions have tax consequences gets more complicated.
Digital Assets as Property
The IRS has ruled that virtual currency is property as opposed to actual currency. So, the tax rules applicable to property transactions in general apply to transactions using virtual currency. For example, when you sell virtual currency, you report a gain or loss as you would upon the disposition of any other property and you must recognize any capital gain or loss on the sale.
Your gain or loss will be the difference between your adjusted basis in the virtual currency and the amount you received in exchange for the virtual currency, which you should report on your federal income tax return in U.S. dollars. Capital gain or loss is short-term or long-term, depending upon how long the virtual currency has been held.
Market Value of Digital Assets
The most common source used to determine market value of a virtual currency is the value published on the currency’s exchange. For example, the value of Bitcoin is available throughout the day, similar to stock prices. If the market value of a cryptocurrency is not posted on an ongoing basis, the burden is on the taxpayer to employ other defensible methodologies such as comparisons with similar digital assets.
Wages Paid in Digital Currency
Cryptocurrency-friendly businesses are increasingly accepting virtual currency as payment for goods or services or to pay employees, independent contractors and suppliers. The amount of the payment is recorded using the market value of the virtual currency at the time of the transaction.
The virtual payments you receive as an employee or contractor are subject to the same federal income tax withholding and reporting as other income. They are expressed in U.S. dollars at the date of receipt. Employee wages are subject to FICA and FUTA tax and reported on Form W-2.
Once an employee receives the compensation in a taxable transaction, they take tax basis in the virtual currency equal to the amount of income recognized. From that point forward, the employee essentially becomes an investor in the property that was received, subject to capital gain rates on any gain or loss recognized at disposition.
Your accountant is in the best position to help you negotiate the challenging and ever-changing world of digital assets. As in any activity that could change your tax liability, conferring with your tax professional in advance of digital activities will enable you to plan for the best outcome.
If you have questions about this featured topic or other accounting and tax related topics, please do not hesitate to contact us at 727-327-1999 OR [email protected].
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