March 3, 2021
New NTA Blog: Wait, When Did This Virtual Currency Question Appear on My 1040 Tax Form?
Are you one of those early birds who has already sat down to prepare your 2020 tax return? Notice anything different right under your name and address? This year, near the top of Form 1040, U.S. Individual Income Tax Return, you will be asked: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” In response, you must check the box “yes” or “no” before your return will be accepted for electronic submission. No one should take this question lightly.
In answering that question, you will have to ask yourself a threshold question: At any time during 2020 did I own virtual currency, which includes all cryptocurrencies? If the answer to that question is yes, then you must ask yourself several other questions including: Have I paid for goods or services with virtual currency? Did I receive virtual currency in exchange for goods or services? Did I sell virtual currency during 2020? Do I have records documenting all of my purchases, sales, and exchanges? Did I report all my sales and exchanges and calculate my gain or loss resulting from the increase or decrease in value of my virtual currency? Do I report my gains and losses as short-term or long-term capital gains or losses? What records should I maintain? Well, you are not alone in asking those questions. And there is confusion with the word “acquire” in the wording of the question and the instructions.
The IRS instructions for the Form 1040 provide clarity and explain, “If, in 2020, you engaged in any “transaction” involving virtual currency, check the “yes” box next to the question on virtual currency on page 1 of Form 1040 or 1040-SR.” Purchase of goods or services with Apple Pay, Google Pay, Cashapp, Venmo, or PayPal using real currency are not considered virtual currency. At the urging of my office, the IRS provided additional guidance by way of a frequently asked question (FAQ) to clarify the use of the term “acquire.” The FAQ states:
Q5: The 2020 Form 1040 asks whether at any time during 2020, I received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. During 2020, I purchased virtual currency with real currency and had no other virtual currency transactions during the year. Must I answer yes to the 1040 question? (3/2021)
The IRS is not seeking information from taxpayers that do not have taxable transactions. The instructions define a “transaction” involving virtual currency as including but not limited to:
A transaction involving virtual currency does not include the holding of virtual currency in a wallet or account or transferring virtual currency from one wallet or account you own or control to another that you own or control.
Make sure you familiarize yourself with the rules or seek the advice of a tax professional. Remember you are signing your tax return under penalty of perjury and are stating that to the best of your knowledge and belief, it is true, correct, and complete. Additional tax, penalties and interest could be assessed if it is determined you have a taxable virtual currency transaction you failed to report. If your only activity was holding virtual currency or transferring it between your own accounts in 2020, it does not qualify as a “transaction” for tax purposes and taxpayers can check the “no” box.
Reader Beware: This post is not intended to answer all questions regarding virtual currency or provide tax advice. Rather, it is intended to inform taxpayers about some complexities and to raise questions you may need to address in reporting your virtual currency transactions.
Decentralized virtual currency was developed around 2009 and has been growing exponentially in popularity and acceptance. Companies such as Tesla, Microsoft, and PayPal are now accepting Bitcoin worldwide, and market analysts estimate there is over $1.6 trillion of virtual currency in circulation, over half of which is Bitcoin.
Banks and money service businesses (institutions) and individuals should be mindful of this effort and proceed with care.
The sale or exchange of virtual currency, including its use to pay for goods and services, has tax implications. These transactions are a disposition of the virtual currency that results in taxable gains or losses, just like a transaction involving any other property. The IRS treats virtual currency as property for federal income tax purposes and the general tax principles applicable to property transactions apply to transactions using virtual currency. The IRS addresses the tax treatment of virtual currency transactions in Notice 2014-21, Revenue Ruling 2019-24, and Publication 544, Sales and Other Dispositions of Assets. The IRS has also posted in-depth Frequently Asked Questions regarding virtual currency on its website. But be warned, you may need to brew a strong pot of coffee to digest the guidance.
In the marketplace, virtual currency is being used to pay for goods and services. These transactions are taxable events. For example, if an employer pays its employees with Bitcoin (or another virtual currency), the employer must report the employees’ earnings to the IRS on Form W-2, Wage and Tax Statement. Conversely, the employees must report the receipt of virtual currency as wages and include it in income. To compute the value of the Bitcoin, the employer must first convert the Bitcoin to U.S. dollars as of the date each payment is made. Wages paid in Bitcoin are also subject to withholding to the same extent as dollar wages. Employers paying in virtual currency, such as Bitcoin, will themselves experience a realization event and will need to calculate and report taxable gain or loss for the virtual currency they use to pay wages.
For Federal income tax purposes, virtual currency is treated as “property,” not currency. This means that a transaction involving virtual currency, such as a sale or exchange, results in capital gain or loss. Thus, IRS guidance explains, “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.” For each transaction, taxpayers will need to compare the cost basis of the virtual currency they are using (generally the amount paid for the virtual currency) against the fair market value (FMV) of the goods or services they are receiving in exchange. If the FMV they receive exceeds their basis in the virtual currency, they will recognize income. On the other hand, if the basis in the virtual currency exceeds the FMV of the property or services received, taxpayers can claim a loss.
To further illustrate, let’s assume you are a savvy investor and purchased ten units of virtual currency for $1,000 ($100 each) that appreciated in value to $4,000 ($400 each) during a 12-month period. For the holidays, you want to update your kitchen with new appliances that cost $2,000 from a vendor that accepts both U.S. dollars and virtual currency. You have two options for how to accomplish this transaction: you can either pay for the appliances directly with the virtual currency, or you can cash in $2,000 worth of virtual currency at an exchange and take away the dollars you will need to pay for the appliances. The tax outcome is the same either way.
In this example, you would have a $1,500 gain, whether or not you transfer the virtual currency directly to the vendor or cash it in through an exchange, which might be surprising to some taxpayers. The gain is determined by calculating the difference between the cost basis of the virtual currency and the amount received. In this transaction, you are disposing of five units of virtual currency with a cost basis of $500 ($100 each). In return for the five units of virtual currency, you receive $2000 ($400 each) of cash from the exchange or goods from the kitchen appliance vendor. Thus, you have a taxable gain of $300 per unit ($400 minus $100) for a total gain of $1,500.
Because the IRS treats virtual currency as property for federal income tax purposes, profit or loss on a virtual currency transaction typically results in capital gain or capital loss. There are two capital transactions:
Taxpayers that transact using virtual currency (including a purchase, sale, or exchange) need to keep records documenting both the purchase/acquisition and the sale/exchange to calculate their gain or loss. This includes the type and value of each unit or partial unit of virtual currency acquired, the amount paid, the cash or goods/services received, and the date and time of the transaction. Taxpayers must report gains and losses on each transaction, even if the gain or loss is small. The IRS requires taxpayers to report all income whether or not they receive a tax form such as a Form 1099 (used to report various types of income). Questions can arise as to how to do the calculation, especially when you make multiple acquisitions and transactions; therefore, we recommend you familiarize yourself with the IRS guidance at https://www.irs.gov/businesses/small-businesses-self-employed/virtual-currencies.
As with all positions taken on tax returns, it is important to maintain records sufficient to justify positions relating to virtual currency transactions. To understand how recordkeeping works for virtual currency transactions in comparison with transactions involving other property, it will be useful to briefly outline the foundational technology used by most virtual currencies.
The underlying technology of most virtual currencies utilize blockchain and distributed ledger technology. Blockchain is a system for organizing data that links a new data entry to the prior entry, and that holds promise for a variety of applications. Most virtual currencies such as Bitcoin, use blockchain technology to record transactions sequentially which are then publicly available in a distributed ledger that is decentralized and exists in as many copies as there are users. Many virtual currency transactions are recorded on the distributed ledger; however, if you buy, sell, or exchange your virtual currency through a virtual currency exchange, then the transaction may not be recorded on the distributed ledger.
Because a virtual currency’s distributed ledger is public, taxpayers can utilize information contained on the blockchain to help substantiate transactions that are recorded on the distributed ledger. However, taxpayers are required to maintain contemporaneous records, such as receipts, statements, and invoices, that are used to calculate their tax liability and justify their tax positions. This is important for virtual currency users who may not receive information returns, such as Forms 1099-MISC, Miscellaneous Income, 1099-K, Payment Card and Third Party Network Transactions, or 1099-B, Proceeds from Broker and Barter Exchange Transactions, that may be provided to those dealing in other types of assets. For transactions that occur “off-chain” and are not recorded in public ledgers, taxpayers must maintain records documenting the transactions, including the amount of money or value of property or services received and the date and time the transaction would have been recorded if it were an “on-chain” transaction. There are many third-party companies that offer services to help taxpayers’ aggregate their transactions and calculate their gain or loss.
Like taxpayers engaging in transactions involving stock or other property, taxpayers using virtual currency for multiple purchases and sales are subject to complex recordkeeping and reporting obligations. Computing the gains and losses fall on the virtual currency holders. One option for taxpayers is the availability of tax software which can assist in tracking transactions. Exchanges like Gemini, Coinbase and Kraken, maintain transaction records for five years and may be used to calculate tax gains or losses. Taxpayers should also familiarize themselves with IRS forms, such as Form 8949, Sales and Other Dispositions of Capital Assets, to report each transaction that qualifies as a capital gain or loss, and Schedule D of the Form 1040, which is a summary of annual capital gains and losses.
The validation of virtual currency transactions, such as Bitcoin, requires increasingly large amounts of computing power and electricity, but despite the increasing cost, users are incentivized to devote computing power to this process, which is known as “mining,” by the promise of earning a certain amount of virtual currency as a reward when a new block is validated for recording on the blockchain. The result of mining is that users receive newly created units of the virtual currency in return for their mining services without the exchange of other currency or assets. The IRS treats the receipt of virtual currency in return for mining services as a taxable event resulting in ordinary income and the sale or exchange of the virtual currency as a second taxable event resulting in capital gain or loss (unless held as inventory), whether or not the receipt and disposition occur in the same or different years.
For example, if you earn $1,000 worth of Bitcoin in return for your mining services today, you’ll add that amount to your taxable income for the year. When you eventually sell or exchange the Bitcoin, the $1,000 you included in income is your basis to determine if you have a taxable gain or loss upon this later sale or exchange transaction. The date and time the Bitcoin is mined is permanently recorded in the blockchain.
Financial reporting rules are coming soon that may impact your opportunities and obligations.
Bitcoin and other virtual currencies can be used to purchase goods and services, or can be bought, sold, or traded as assets. Privacy and decentralization are key aspects of most virtual currencies, and a certain portion of the market in virtual currency is purportedly devoted to illicit activity ranging from drug deals to the illegal weapons trade. Given the potential of virtual currency to be used for concealment and criminal dealings, the Treasury and the IRS are heavily focusing on virtual currency transactions.
One mechanism in regulations recently proposed by the Financial Crimes Enforcement Network (FinCEN), would require banks and money service transmitters like virtual currency exchanges to record transactions and report them to FinCEN in certain situations. Central to these proposed regulations are the definitions of what FinCEN considers “hosted” and “unhosted” wallets (or accounts). Hosted wallets are those opened and maintained by third-party financial institutions on behalf of their customers, while unhosted wallets generally remain with the owner of the virtual currency and are stored in various locations ranging from personal computers to external hard drives.
Under the regulations, transactions involving counterparties with unhosted wallets or transactions involving counterparties with accounts in foreign jurisdictions designated as high-risk for money laundering will be subject to currency transaction reporting (CTR) when transactions aggregate to greater than $10,000 per day (records alone must be kept if they aggregate to more than $3,000 per day). The reporting will be implemented by treating the transactions as involving monetary instruments and bringing them within the standard CTR regime. Transactions between hosted wallets in reputable jurisdictions are exempt from this reporting and recordkeeping requirement, as they have inherent transparency. Individuals with hosted wallets in reputable foreign jurisdictions should be able to obtain documentation from their institutions to facilitate the reporting. There may be a range of consequences from these proposed regulations. For instance, institutions may shy away from facilitating transactions with unhosted wallets to avoid the reporting requirements. If that reaction were widespread, it could limit the ability of individuals to engage in transactions with unhosted counterparties.
While the proposed FinCEN regulations would impact the operations of institutions, FinCEN has also published a notice announcing the intention to require individuals possessing foreign accounts solely designated to hold virtual currency to file the Report of Foreign Bank and Financial Accounts (FBAR). These accounts are not currently considered reportable accounts, although a foreign bank account containing a mixture of virtual currency and other assets is reportable under present regulations. This proposed reporting change would bring consistency to the treatment of virtual currency and other amounts held in foreign bank and financial accounts.
Individuals with foreign accounts holding solely virtual currency should be careful to observe and comply with these FBAR requirements whenever they become applicable. Those owning foreign accounts must file an FBAR if the aggregate value of the accounts exceeds $10,000 at any point in the calendar year. Presumably, these same rules will be applied with virtual currency. The penalties for failing to report are significant. Individuals with covered accounts should monitor the requirements being developed and proceed accordingly.
FinCEN reporting requirements relating both to institutions and to individuals do not directly impact taxation, as they are not imposed for IRS purposes. On the IRS side, the interaction of reporting under section 6038D (Form 8938, Statement of Specified Foreign Financial Assets) and virtual currency is perceived by some practitioners to be in flux, and the IRS’s definitions for tax are not identical with those used by FinCEN. Both taxpayers and the IRS would benefit from clear and reliable guidance relating to the reporting and taxation of virtual currency held abroad. Absent such guidance, taxpayers and practitioners are forced to make their best guesses at how and when to report virtual currency on Form 8938 with the potential for serious financial consequences if they are wrong.
Using virtual currency has continued to expand as an investment vehicle, to make online purchases, and occasionally to facilitate large-scale purchases. The IRS and state agencies have increased their enforcement activities regarding potential unreported taxable transactions and events. For example, in 2016 the IRS served a “John Doe” summons on Coinbase, one of the largest virtual currency exchanges in the U.S., seeking information from a wide range of records and documents regarding U.S. persons’ virtual currency transactions from 2013 through 2015. Once produced, the IRS may use that information, and information received from other sources, with individual audits to determine if income was properly reported.
Because virtual currency is used for investment and in exchange for goods and services, the IRS’s approach to generally treating virtual currency as property that can be held as a capital asset is generally taxpayer-favorable because capital gains rates may result in less tax. In addition, characterizing virtual currency property that can be held as a capital asset, in the same way as stock, allows taxpayers to control the timing of transactions that trigger taxation. Further, by giving taxpayers the choice of which units within a wallet or account are deemed sold or exchanged, such as the units first or last acquired, with highest or lowest basis, or specifically identified, the IRS furnishes taxpayers with an additional tool for managing their liabilities. Of course, similar to other asset, taxpayers must be able to establish their basis and keep other records needed to support positions taken on their tax returns.
Meanwhile, taxpayers should be aware that the IRS continues to focus on virtual currency gains to determine whether systematic underreporting is occurring, and if so, to commence enforcement actions related to virtual currency tax fraud. Taxpayers, institutions, and entities should familiarize themselves with the complexities of the tax and financial reporting rules and understand the reporting obligations when undertaking virtual currency transactions. Failure to do so could result in penalties and other negative consequences that exceed the potential benefits from utilizing virtual currency. Thus, taxpayers should enter this developing realm with due care so as to recognize its benefits while avoiding its pitfalls.
As virtual currency becomes more widely used to facilitate small purchases and mundane transactions, the IRS may also want to consider providing a safe harbor reporting mechanism for these smaller transactions. The recordkeeping for virtual currency transactions for purchases of a $10 item, restaurant charge, or other incidentals seem to be overly complex and burdensome for the average taxpayer opting to use virtual currency. Continuing to publish guidance and posting frequently asked questions will provide taxpayers the guidance they need to file correct tax returns and eliminate future controversies. As it is too late to amend the Form 1040 and instructions, my office continues to recommend the IRS reword the virtual currency question on the 1040 together with the instructions for the 2021 Form 1040. The IRS should provide clear guidance for those taxpayers who merely purchased or acquired virtual currency during the tax year but did not conduct a taxable transaction. These individuals are not and should not be required to check the box “yes”.
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.