As first published on Bloomberg’s Daily Tax Report.

Key Takeaways

• The Internal Revenue Service is obtaining significant records about virtual currency holders
• These records not only implicate taxpayers who sold virtual currency at a profit, but also anyone who bought, sold, sent, or received virtual currency
• Exchanges of one virtual currency for another, mining of virtual currency, and receipt of units like Bitcoin Cash can create current tax obligations
• These issues have criminal and civil implications, and IRS pressure will only increase

It is no secret that the value of many virtual currencies (in particular, cryptocurrencies such as Bitcoin) rose over the past year. The associated legal and tax challenges are less well-known but vitally important (at least for those looking to avoid potential criminal and civil penalties). As the April tax deadline fast approaches, one of the most notable issues affecting holders of virtual currency is their tax reporting obligations.

As noted in a March 23, 2018 press release on the issue, IR-2018-71, the IRS argues that the sale of all assets, including virtual currencies, must be reported on an individual’s federal income tax return. Based on its own review, the IRS argued that fewer than 1,000 taxpayers reported virtual currency sales on their tax returns between 2013 and 2015, for example. While virtual currencies were certainly less well-known three to five years ago than they are today, a court recently found the IRS argument persuasive enough to order disclosure of thousands of names and records.

Bought, Sold, Sent, or Received

As part of a federal summons enforcement proceeding in the U.S. District Court for the Northern District of California, the IRS will receive the names and personally identifiable information of more than 13,000 virtual currency account holders. This includes account holders who met or exceeded the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in 2013, 2014, or 2015. Notably, it does appear to exclude account holders who only bought and held Bitcoin during the 2013 through 2015 period, or those who received a Form 1099-K. While the recent proceedings involved Coinbase, the U.S.’s largest digital currency exchange, IRS demands for records will touch many more companies and users going forward.

Thus far, IRS demands for records are not limited to virtual currency sales or transactions that actually produced a profit in U.S. dollars. This goes to a broader consideration for virtual currency holders—transactions such as an exchange of one virtual currency for another are taxable events, and what triggers tax recordkeeping requirements may surprise some holders.

A taxpayer, for example, might use Bitcoin or Ethereum to acquire one of the many other virtual currency offerings that debut on a near-weekly basis. Under the law informally known as the 2017 Tax Cuts and Jobs Act, these exchanges must be reported to the IRS. If the virtual currency given up in the exchange is worth more than what was paid for it (or reported upon being mined), then income tax will be due from this exchange. In essence, exchanging one virtual currency for another is treated no different than a sale for U.S. tax purposes. The IRS will undoubtedly review tax returns to determine if these exchanges of virtual currency are being reported.

To date, the IRS has issued limited guidance on reporting exchanges of virtual currency. IRS Notice 2014-21, states that virtual currency should be treated as “property” for tax purposes. Because virtual currency is treated as property, not currency, there are several less-than-familiar scenarios in which an individual may be unaware that reporting is required. Specifically, miners and those who exchange one virtual currency for another have current reporting obligations, described further below.

Acquiring Virtual Currency and Mining

An individual can “mine” virtual currency by using their “computer resources to validate [virtual currency] transactions and maintain the public [virtual currency] transaction ledger.” IRS Notice 2014-21 (specifically referring to Bitcoin). A U.S. taxpayer must report as gross income the fair market value of the virtual currency that they obtain from mining.

In addition to having gross income to report, the IRS expects that an individual who mines as a trade or business will report and pay both income and self-employment taxes. This means that individuals mining virtual currencies may be liable for quarterly tax payments throughout the year, even if they have not sold any of the units they mined. It is essential for miners to maintain proper books and records to track income and expenses. Income is dependent on the value of the virtual currency the day it is discovered. Mining-related expenses for computer equipment and electricity can be very high and can be deductible for people conducting their mining operations as a business.

The timing of a miner’s virtual currency sale could also affect the character and tax rate of the sale proceeds. Proceeds from currency mined and held for over one year should be considered long-term gain, while currency held for less than one year is short-term gain (and typically has a higher tax rate). This is another reason why tracking the dates on which currency is obtained and then sold is critical.

No More Possibility of Like-Kind Exchanges

Like-kind exchanges are transactions that allow a person to exchange property for “like” property within six months without immediate tax implications. For sales prior to 2018, it is arguable that an exchange of one virtual currency for another (e.g., Bitcoin for Ethereum) could qualify as a non-taxable like-kind exchange. Beginning Jan. 1, 2018, Congress amended the like-kind exchange rules to no longer apply to virtual currency (or anything other than real property). Now, there is no question these virtual currency exchanges are recognition events. Because digital currency exchanges are not explicitly required to report these transactions to users on a Form 1099, this remains a trap for the unwary.

Distributions to Holders

On Aug. 1, 2017, Bitcoin Cash emerged after a hard fork in the Bitcoin blockchain. Many who held Bitcoin on August 1, automatically became owners of Bitcoin Cash coins as a result. There also have been dividend-like distributions of one type of virtual currency to holders of another type. From a taxpayer’s perspective, these types of transactions could be treated in similar fashion to stock-splits or dividends or even another alternative, depending on the facts and how the IRS construes these events. This creates yet another question of when and what amounts must be reported.

Conclusion

The broad takeaway is that U.S. taxpayers who have held any virtual currency should be very wary of government scrutiny. U.S. taxpayers under investigation or those who believe they sold, exchanged, or sent virtual currency through any exchange or medium should consider their options with great care to minimize exposure to criminal liability and civil penalties. With limited IRS guidance currently available, it is in taxpayers’ best interest to establish a clear reporting plan as soon as possible.