The IRS recently publicized that it will be cracking down on taxpayers for not properly reporting cryptocurrency transactions. In this article, we’ll summarize different types of transactions and how the IRS has recommended they be reported.
We have used the terms “virtual currency” and “cryptocurrency” interchangeably.
What Is Cryptocurrency?
Cryptocurrency is a digital currency or decentralized system of exchange that advances cryptography for security. In other words, it works similarly to cash in the U.S. fiat currency system. People who own a unit of cryptocurrency can exchange it for U.S. dollars, services, or for a different type of cryptocurrency. One of the main benefits of a cryptocurrency, like Bitcoin, is that no single entity controls the ledger. In that regard, its legitimacy is well-established; it is very difficult if not impossible to counterfeit. One potential drawback, however, is that the cryptocurrency market is currently unregulated in the U.S. There are over 1,000 types of cryptocurrencies available, with Bitcoin enjoying the most name recognition.
Bitcoin and other virtual currencies may also have a bad reputation in some people’s eyes. Many criminals fund their illegal activities using virtual currencies, exchanging billions of dollars annually for drugs and ransomware or malware attacks. Virtual currencies attract these sorts of people because of the higher degree of anonymity associated with transactions. It is difficult, but not impossible, to link the components of these transactions to someone’s personal identity. This is another reason why the IRS has renewed emphasis on underreporting of virtual currency transactions.
IRS Stance On Cryptocurrency
In the summer of 2019, the IRS sent notices to selected taxpayers indicating that the taxpayers’ returns were under review because the taxpayer may have underreported their cryptocurrency transactions on their recently-filed tax returns. Many of these notices required a response from the taxpayer under penalties of perjury. The penalties associated with underreporting cryptocurrency transactions can be significant.
The IRS issued guidance on how taxpayers should report their cryptocurrency transactions. They have also answered frequently asked questions on virtual currency transactions.
As a general rule of thumb, the IRS considers cryptocurrencies as property, similar to a stock. If an individual converts a unit of cryptocurrency to cash, the taxpayer should report that transaction on Schedule D, “Capital Gains and Losses.” The gain or loss reported would be the difference between the selling price of the cryptocurrency and its cost basis. The holding period is similar to stocks in that you can have a short-term gain or loss if you held the currency less than one year and have a long-term gain or loss if you held it longer than one year. Many times, cryptocurrencies are administered through an online exchange and this information, the selling price and basis, is available from the exchange. However, the taxpayer will not receive a Form 1099 for these transactions and they are not automatically reported to the IRS.
Taxpayers should also similarly report when they exchange cryptocurrency for services. If you perform a service for someone and, in exchange, are paid in a virtual currency, you should report that as income at the fair market value of the currency on the date of the exchange. The payer of that virtual currency (in this example, the person receiving your services) would report a gain or loss depending on their basis and the fair market value on the date you rendered the services.
What You Should Do
In 2019, the IRS added a question to Schedule 1 about the taxpayer’s virtual currency activity. In 2020, they relocated that question to the front page of the Form 1040 to emphasize its importance.
If you are required to complete this schedule, you must answer this question. Many taxpayers will be required to complete this form, which summarizes income from partnerships, S corporations, rentals, and sole proprietorships as well as IRA contributions and some health insurance.
If you own a business that accepts virtual currencies in exchange for products or services or pays for products or services with virtual currencies, you should ensure that the reporting of these transactions is in accordance with generally accepted accounting principles for financial reporting purposes. You may also want to discuss these transactions with your bank, as they may have an impact on your bank covenants or loan agreements.
If you own, sold, purchased or exchanged any virtual currency during the year, you should discuss the impact of this with your tax preparer, ideally before the end of the year as part of your periodic tax planning. Obtain a list of all currencies you owned on January 1, and compare it to all of the currencies you own at December 31. If there is no change in quantities and you didn’t have any transactions during the year, there shouldn’t be any impact. Otherwise, obtain a list of when you obtained the currencies owned, how you obtained them, how much you paid for them, and the nature of your transactions during the year. Many virtual currency exchanges keep records of your activities through the exchange, allowing you to match up purchases, sales and other transactions for your selected period of time so you can create a report for tax reporting purposes.
As we stated earlier, the penalty for not properly reporting these transactions can be severe, so it is best to be transparent with the IRS and pay any tax timely as a result of your cryptocurrency activities.
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Editor's note: this article was updated on December 14, 2021.
