Don’t Be Too Cryptic About Handling Your Cryptocurrency

By: Randall A. Denha, J.D., LL.M.

Bitcoin first emerged on the scene in November 2008 and in January 2009, the peer-to-peer Bitcoin network first came online. Bitcoin works on the basis of what is known as the “blockchain.” The blockchain is a digital public ledger where every Bitcoin transaction that has ever occurred and ever will occur is recorded. The blockchain is the fundamental basis for Bitcoin and users of the technology have the option to contribute computing resources towards maintaining the public ledger. Individuals who contribute resources are said to be “mining” for blocks of bitcoins. When certain conditions are met, Bitcoin miners can be compensated through the award of new Bitcoins.

Only seven years ago, on what is commemorated as “Bitcoin Pizza Day,” Bitcoin, then a new crypto currency, was worth hardly anything. So, in May 2010, early Bitcoin enthusiast Laszlo Hanyecz exchanged 10,000 bitcoins with another programmer for two Papa John’s pizzas (worth about $25), to show that bitcoins could actually be used to buy things. The value of those 10,000 bitcoins today is a stunning $45M, and some businesses, such as Overstock.com, accept bitcoins directly as payment for goods (thus, a bitcoin owner can exchange bitcoins for a product, using it in somewhat the same manner as fiat currency).

Is Bitcoin Taxable Income?

While the exact circumstances and use of the digital currency will determine whether Bitcoin is considered income in that specific scenario, it certainly is possible and reasonably common for Bitcoin to be considered income. Some scenarios where transfers or payments of Bitcoin may be considered taxable income include:

• You contributed computing resources and successfully mined a full or partial Bitcoin.
• You performed work as an employee and received compensation in the form of Bitcoin.
• You worked as an independent contractor who was paid in Bitcoin.
• You run a retail store or an online business and accept Bitcoin as payment for goods or services.

The above sets forth only some of the more basic and common scenarios where Bitcoin is considered taxable income. Please remember that all income is subject to income tax even if your employer fails to issue a W-2, 1099, or other informational tax documents.

What Tax Treatment Does Bitcoin Receive?

First, the IRS cares about cryptocurrency because trading in cryptocurrency is a taxable event and converting cash to a virtual currency could be a way to launder money.  In Notice 2014-21, the IRS announced the tax treatment that Bitcoin would receive. This notice gave guidance on everything from paying employees with cryptocurrency to how the various trades between different currencies are treated. While many people would expect for Bitcoin to be treated like other types of currency for tax purposes, it is not. Rather, Bitcoin and similar digital currencies should be treated as property for tax purposes. The IRS bases this determination on the fact that, unlike traditional currencies, Bitcoin is not regulated or governed by a national government or a central bank. Furthermore, Bitcoin does not have legal tender status in any nation or jurisdiction.

As such, Bitcoin and other similar digital currencies are treated as property. At present, the IRS considers cryptocurrencies to be “intangible assets.” As a result, they are subject to capital asset treatment.  When assets receive tax treatment as property, it means that parties must consider and account for gain that occurs. The failure to account for capital gains can result in significant tax penalties. Meanwhile, the failure to account for capital losses may mean that you are paying more in tax than is required.

At a minimum, U.S. taxpayers who hold and transfer Bitcoin should record the value of Bitcoins when they are obtained. They should also record the value of Bitcoins when the digital currency is sold, traded, transferred, or otherwise disposed of. The difference is value is the capital gain or loss.

Typically, the gain or loss is recognized at the time of the transfer. Taxpayers should be sure to account for all capital gain and loss associated with Bitcoin transactions. The failure to do so can result in tax penalties and interest.

Can Cryptocurrency splits qualify as 1031 exchange property?

I am aware of certain individuals arguing that cryptocurrency splits such as Bitcoin Cash qualify as tax-free exchanges.  My suspicion is that this will not pass muster with the IRS since none of the corporate reorganization non-recognition events under the tax code apply (IRC 368.) Bitcoin Cash is economically different from Bitcoin, and therefore should be viewed as a new category of financial instrument.

What does the IRS think? 

About 10 to 15 years ago, the IRS began serving “John Doe” warrants to foreign banks to compel those banks to release the names of account holders on certain bank accounts. This was followed by a tough crackdown by the IRS on taxpayers who failed to file their foreign bank accounts (and face stiff penalties for not filing, including jail time). Over the past several years, many investors sold cryptocurrencies, including Bitcoin, but did not report any taxable income from the transactions, while others used Section 1031 like-kind exchange laws to postpone taxation. The IRS is none too pleased by all of this and is taking action.

Fast forward to present day, in November of 2016, a federal judge in the Northern District of California granted an IRS application to serve a John Doe summons on Coinbase Inc., which operates a virtual currency wallet (for many different types of digital assets with currencies in over 30 countries with storage in over 190 countries) and exchange business. The summonses asked Coinbase to identify all United States customers who transferred convertible virtual currency from 2013 to 2015. At that point, Coinbase dealt only with bitcoin. Coinbase is not the only medium for trading cryptocurrencies. Largely, cryptocurrency has gone unregulated, so these warrants are issued to level the playing field for the government. It is my opinion that the IRS has only just begun its targeting and more will follow. Unlike money issued by governments, cryptocurrency has no Federal Reserve, no gold backing, no banks, and no physical notes. Thus, it has the potential for being used in illegal activities. A criminal could simply convert “dirty money” gained through an illegal activity to something like bitcoin and use it to trade for goods and services.