Virtual currencies such as Bitcoin, Ethereum, Litecoin, and Ripple are undoubtedly gaining traction. However, their increasing acceptance by the public also bears increased scrutiny by the IRS for reporting and compliance as the value of these virtual currencies can fluctuate significantly. Therefore, the IRS launched Operation Hidden Treasure to root out taxpayers who do not report earned income from cryptocurrency transactions on their federal tax returns. When you buy, sell, or engage in virtual currency transactions, you should stay up-to-date with the latest tax developments.
Terminology
Virtual currency is an intangible electronic asset not regulated by any government or authority. IRS guidance defines virtual currency as a “digital representation of value that functions as a medium of exchange, a unit of account, or a store of value.” For example, Bitcoin was one of the first virtual currencies created, and it exists on a digital ledger system known as Blockchain.
Taxation of Virtual Currency Transactions
For federal tax purposes, virtual currency transactions are subject to the same rules applying to property purchases. Several types of virtual currency transactions can trigger reporting obligations, including:
Sales: If selling virtual currency, you must report any capital gain or loss on the sale on your federal income tax return in U.S. dollars. These gains or losses must equal the difference between your adjusted tax basis in the currency and the amount received.
Property Exchanges: When exchanging virtual currency as a capital asset, you must report it as a gain or loss. These gains or losses represent the difference between the fair market value and the adjusted basis exchanged.
Payment for Services: When receiving virtual currency for performing a service, the taxpayer should report the fair market value of the payment and the date received. If paying for a service using virtual currency, you have exchanged a capital asset and will have a gain or loss.
Wages: Employers who offer compensation using virtual currency must accurately report the amount on Form W-2, and this money is taxable. The fair market value is subject to federal income tax withholding and payroll taxes. If an independent contractor or service provider receives virtual currency payments, the compensation is taxable and should be reported through a 1099-NEC. In most cases, the established rules for self-employment tax apply.
Reporting Obligations
Taxpayers must report all cryptocurrency transactions on their tax returns, including buying, selling, and trading. Taxpayers should record the dates purchased, the purchase price, and the proceeds of all virtual currency transactions. The IRS guidance on the reporting of virtual currency transactions states:
The specific question regarding virtual currencies has moved to the first page of Form 1040 directly beneath the taxpayer’s general information. If a taxpayer purchased virtual currency with real money and had no other transactions, they are not required to answer “yes” to the question on Form 1040. This question previously appeared on Schedule 1.
Taxpayers selling virtual currency must report the sale on Schedule D of Form 1040. Unlike stocks held in brokerage accounts, virtual currencies typically are not on a Consolidated 1099 Tax Statement. Taxpayers may receive a 1099-K or 1099-B related to their virtual holdings and must report their customers’ gains and losses on the sale of securities during the tax year to the IRS. The issuer sends all copies of the 1099 forms to the taxpayer and the IRS. If a 1099 form is not issued, the taxpayer must determine the cost basis and sales price.
Failure to report transactions conducted using virtual currency can have severe tax consequences. Taxpayers should inform their tax professionals of all virtual currency transactions that year to avoid penalties and stay in compliance with the IRS.
Infrastructure Investment and Jobs Act
The Infrastructure Investment and Jobs Act created new reporting requirements for digital asset transactions. The requirements provide the IRS with more information to work from and establish more potential compliance tripwires for taxpayers who engage in virtual currency transactions.
Under the new law, operators of trading platforms for digital assets, such as cryptocurrency exchanges, are subject to similar reporting requirements as traditional securities brokers. After the new rules take effect, cryptocurrency platforms must collect Form W-9, “Request for Taxpayer Identification Number and Certification,” from their customers.
It also amended existing anti-money laundering laws to treat digital assets as cash for purposes of those laws. As a result, beginning in 2023, businesses must report to the IRS when they receive more than $10,000 in digital assets in one transaction or multiple related transactions on IRS Form 8300, “Report of Cash Payments Over $10,000 Received in a Trade or Business.”
Enforcement Tool
The Inflation Reduction Act allocated $80 billion over ten years to the IRS, with most of the money designated for enforcement activities. However, the Fiscal Responsibility Act will claw back $21.39 billion by 2025. The IRS’s strategic operating plan for 2023 through 2031 lays out the agency’s intent to ramp up enforcement related to digital assets.
Furthermore, the IRS may uncover digital assets through a “John Doe Summons.” The U.S. Department of Justice notes that “because transactions in cryptocurrencies can be difficult to trace and have an inherently pseudo-anonymous aspect, taxpayers may be using them to hide taxable income from the IRS.”
Here to Help
The IRS’s focus on virtual currency transactions is likely to intensify. If you have questions about compliance issues or reporting virtual currency transactions, contact us today! We will take the cryptic out of crypto taxation.