One of the most popular, yet often misunderstood, financial topics of the past few years have been the rise of the so-called virtual currency. From Bitcoin to Zcash, including a myriad of other similar offerings, cryptocurrencies have become all the rage. Yet, if the virtual currencies themselves are shrouded in a bit of mystery to most, it stands to reason that taxation for those involved is an even bigger enigma.
What Exactly Is Virtual Currency, and Why Do Some Choose to Use Them?
From a traditional standpoint, currency is understood to be physical currency (sometimes referred to as Fiat currency), which is the standard coin and paper money issued by a country or union and is used and accepted as a medium of exchange. However, currency can also be digital, such as credit cards which have stores of value. Virtual currency, in contrast, is a medium of exchange, but is not issued by any country or union.
While uses of virtual currency vary, the primary reasons individuals choose to utilize them are to avoid fees, for investment purposes, allowing banking for unbanked populations, and as an alternative to a national currency.
Are There Different Types of Virtual Currencies?
Yes. In general, there are two types of virtual currencies, nonconvertible virtual currency, and convertible virtual currency. Nonconvertible virtual currency is intended to be used in a domain or digital environment, and cannot be exchanged for ordinary, traditional currency. A way to think of them are online games where the currency is used to purchase goods or services but is confined to that platform. In contrast, convertible virtual currency is a virtual currency that has an equivalent value in real (“fiat”) currency that it can be exchanged for. Bitcoin is the biggest player in this market, but with Facebook’s anticipated announcement regarding a crypto-based payment system called Libra, it will be interesting to see what comes in the months and years ahead. Convertible virtual currencies are also called “cryptocurrency,” which is a term derived from the software-aided cryptography used to control the issuance of new units of currency and to secure and control transactions.
How Does the IRS Treat Virtual Currencies for Tax Purposes?
Needless to say, the Internal Revenue Service (IRS) is aware that “virtual currency” may be used to pay for goods or services or held for investment. Ironically, for federal tax purposes, virtual currency is treated as property, and general tax principles applicable to property transactions apply to transactions using virtual currency. A potential benefit to this is that, since virtual currency is not treated as currency, it cannot generate foreign currency gain or loss (so-called “Forex” gains and losses) for US federal tax purposes.
However, the following points should be taken into consideration when dealing with virtual currencies:
- A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in US dollars, as of the date that the virtual currency was received.
- The basis of virtual currency that a taxpayer receives as payment for goods or services is the fair market value of the virtual currency in US dollars as of the date of receipt.
- For US tax purposes, transactions using virtual currency must be reported in US dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in US dollars as of the date of payment or receipt.
- If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
- The character of a gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets. A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.
- When a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.
- If a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to the self-employment tax.
- Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual as other than an employee. Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in US dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.
- The fair market value of virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement.
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
- Generally, a person who in the course of a trade or business makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099-MISC, Miscellaneous Income. Payments of virtual currency required to be reported on Form 1099-MISC should be reported using the fair market value of the virtual currency in US dollars as of the date of payment. The payment recipient may have income even if the recipient does not receive a Form 1099-MISC.
- Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property.
- Prior to the Tax Cuts and Jobs Act (TCJA), some taxpayers took the position that the exchange of one type of virtual currency for another type of virtual currency was a like-kind exchange subject to Sec. 1031. However, the TCJA limited like-kind exchanges under Sec. 1031 to exchanges of real property that is not primarily held for sale, in general, for exchanges completed after Dec. 31, 2017.
- Taxpayers may be subject to penalties for failure to comply with tax laws. For example, underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties. In addition, failure to timely or correctly report virtual currency transactions when required to do so may be subject to information reporting penalties. However, penalty relief may be available to taxpayers and persons required to file an information return who are able to establish that the underpayment or failure to properly file information returns is due to reasonable cause.
Are There Specific Impacts of Virtual Currencies When It Comes to Expats?
Although the general tax treatment of virtual currencies has an impact on all taxpayers who hold them, expats must consider where their virtual currencies are held in foreign accounts and therefore, subject to foreign account reporting. A digital wallet that holds cryptocurrency is likely considered an account for foreign information reporting purposes. To reinforce international tax compliance, the IRS may require digital wallet owners to comply with FBAR (FinCEN Form 114, Report of Foreign Bank and Financial Accounts) and FATCA (Foreign Account Tax Compliance Act) reporting. In general, it is best to include digital wallets held overseas in these information reports to avoid possible penalties and start the running of the statute of limitation.
Want to Know More About How Virtual Currencies Could Affect You?
Greenback specializes in US expat taxes and can help you navigate all the complexities that can go along with becoming or staying compliant. Located all over the world, our team of experts are here to help get your questions answered. Just reach out and let us know how we can help with your specific situation.