For many years, transactions and earnings in virtual currencies stayed off of tax returns. As the value of cryptocurrencies rose, the IRS began enforcing and clarifying cryptocurrency tax laws. The IRS has updated instructions for 2020 on the virtual currency question on Form 1040, and these instructions clarify what’s included under the term virtual currency. Per the IRS, virtual currency is treated as property, and general tax principles applicable to property transactions apply to transactions using virtual currency. Capital gains on cryptocurrency are taxable, and there also are other situations that trigger a reporting requirement. Those who sold crypto, used it to pay for a service, gifted it, or made a donation of cryptocurrency will need to report it on 2020’s tax return.
What is virtual currency?
The IRS defines virtual currency as a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (real currency), that functions as a unit of account, a store of value, and a medium of exchange. Virtual currency includes digital currency and cryptocurrency—any type of convertible currency that is used as a medium of exchange. Cryptocurrency specifically uses cryptography to secure transactions that are digitally recorded on a ledger, such as a blockchain. You may be most familiar with Bitcoin due to its recent prominence in the news. However, there are numerous other cryptocurrencies, many of which are very popular.
One reason why virtual currencies are gaining popularity is because they are DeFi, or decentralized finance. Rather than one single, central source holding control of the transactions, several entities hold a copy of the transactions. This eliminates the middle man from transactions, such as Visa or PayPal in traditional currencies. DeFi reduces the need for human gatekeepers, which limit the speed and sophistication of transactions. As a result, users have more control over transactions and receive access to advanced technology and capabilities of smart contracts.
What do I need to report on my tax return if I’ve held cryptocurrency?
It’s a common misconception that you only need to report virtual currency transactions if you sold the currency. If you engaged in any of the following types of transactions with cryptocurrency, they’ll need to be reported:
- Purchased a cryptocurrency
- Sold crypto
- Mined bitcoin or other currency
- Paid for a good or service
- Received payment for goods or services
- Gave a gift
- Made a donation
If you sold a virtual currency, you must report it when filing your taxes. If you sold the currency for a profit, it is now considered a capital gain. That’s right—you’ll owe taxes on cryptocurrency gains. If you took a loss when selling your currency, it is a capital loss and can be deducted. The holding period for virtual currencies starts the day after you receive them. If you held the currency for less than one year before selling, then you have a short-term capital gain or loss; longer holdings result in a long-term capital gain or loss.
If you run a business and have been paid with cryptocurrency, you must treat the currency just as you would other forms of income—report it as ordinary income. The same goes for using crypto as a method of paying for a service. If you paid an employee was paid with virtual currency, you must issue a W-2 or 1099. The amount reported is the fair market value of the virtual currency in US dollars on the date of receipt.
If you have received virtual currency as a gift, you do not need to report it at the time of receipt—you’ll do so when you sell, exchange, or otherwise dispose of the currency. This is an opportunity for givers to include in their tax planning.
If you donate virtual currency to a charitable organization, you will not recognize income gain or loss. You can deduct the donation as you would with typical currency or stocks. The amount eligible for a deduction is equal to the fair market value at the time of the donation if you held the currency for more than one year
How should I keep track of my cryptocurrency for tax purposes?
Because the value of the virtual currency is equal to its fair market value, it is vital to keep a proper record of your transactions. There are specific tax software packages designed to help you track your crypto transactions. However, it is important to speak with your tax advisor to ensure you properly report your virtual currency transactions. All apps and software packages have limitations, and the growing regulations targeting cryptocurrencies require a careful review by a knowledgeable tax professional. The IRS will be honing in on crypto transactions and looking for irregularities. Contact us to schedule a consultation if you need assistance handling cryptocurrency.