Cryptocurrency is a new phenomenon that is growing popularity for use in not only investment purposes but also paying for goods and services purchased across the globe. Satoshi Nakamoto, one of the pioneers of Bitcoin, developed Bitcoin to serve as a “Peer-to-Peer Electronic Cash System.” As it is used in transactions and for speculative purposes, its use has tax effects. Let’s look at the tax effects of this new currency and how to report it on your U.S. tax return.
As it is not the official currency of the United States, it could be considered a foreign currency. However, for tax purposes, the IRS has determined that the various forms of cryptocurrency are not a foreign currency, and therefore its use will not create foreign currency gains or losses, which need to be reported for tax purposes.
One of the uses for cryptocurrency is to pay for the goods and services used in your business. Whether to buy parts for the inventory you create or sell or to pay a contractor in another country for the work they did for your enterprise, cryptocurrency can be used to make payments. When payment is made, the payment is to be recorded at the fair market value of the virtual currency on the day you send the payment. If the currency is listed on a currency exchange, you will calculate the fair market value of the payment by converting the virtual currency into US dollars at the exchange rate.
If you use cryptocurrency to pay wages to employees, the amounts paid to the employee are taxable as if they were paid in U.S. dollars. The wages paid need to be reported by you as an employer on the employee’s Form W-2, and the wages would be subject to federal income tax withholding and payroll taxes.
If, however, you are paying an independent contractor with some type of cryptocurrency, these payments are taxable income to the contractor and are subject to the self-employment tax rules applicable to independent contractors. On your end, you will need to issue Form 1099-MISC, Miscellaneous Income, to anyone you pay more than the equivalent of $600 in a year.
Therefore, if you engage in the sale or exchange of virtual currencies, you will need to report the gain or loss on the sales of the currencies, as you would the sales of securities. Whether this is reportable depends on whether the virtual currency could be considered a capital asset to you. A capital asset is something that you would use for purposes, whether for your own pleasure or investment. This would include stocks and bonds, collectibles, and precious metals. As cryptocurrencies would fall under this category if you are buying and selling for your personal purposes, it would be considered a capital asset, and the gain or loss on the sale would have to be reported on Schedule D, Capital Gains and Losses, as well as on Form 8949, Sales and Other Dispositions of Capital Assets.
Capital gains and losses are classified as either short term or long term. If you hold the security, or in this case the currency, for less than a year it is short-term gain or loss. If for longer than a year, it is a long-term gain or loss. If you have long-term capital gains, they can be reduced by long-term capital losses. The same applies to short-term capital gains and losses. If you have a capital loss, you can only deduct $3,000 of the loss in a year, with the remainder rolling forward to the next tax year until you use up the entire amount of the loss.
Most taxpayers will have a tax rate on most net capital gains of 15% for most taxpayers. However, you may be taxed at a 20% tax rate on net capital gains on the amount that your taxable income exceeds the thresholds set for the 39.6% ordinary tax rate. So if you are in the 39.6% tax bracket, you would pay a 20% tax on your capital gain.
In addition to the aforementioned uses of cryptocurrency, one new practice that has come about with the rise of cryptocurrencies is mining. Mining is the processing, recording, and security of transactions done in digital currencies. To do this, you would use computer programs and other resources to validate Bitcoin transactions as well as maintaining the public Bitcoin transaction ledger. When this is done successfully, you will need to include in your gross income the net value of the transaction done in the virtual currency as of the date of receipt.
Do you engage in transactions using some type of digital currency and have questions? Drop me a line at [email protected], and I would be happy to answer any questions about how your taxes will be affected by cryptocurrency transactions. If you need help with other tax questions, or with preparing a return, drop me a line, and we can discuss your situation.
In accordance with Circular 230 Treasury Department Regulations, I am required to advise you that any tax advice contained in this article may not be relied upon to avoid penalties under the Internal Revenue Code. If you are interested in a written opinion that can be relied upon to prevent the imposition of tax-related penalties, please contact the author.