If you use or hold cryptocurrency, also called virtual currency, you need to exercise special care. Challenges arise from the fact that the IRS classifies all virtual currencies as property, not as currency in the usual sense. As a result, any transaction involving cryptocurrency might involve a capital gain or loss that must be reported to the IRS.
Potentially taxable cryptocurrency transactions include:
- Exchanging virtual currency for real currency (for example, trading Bitcoin for US dollars)
- Receiving cryptocurrency as payment for work or services performed
- Selling property and accepting cryptocurrency as payment
- Using cryptocurrency to purchase goods or property
- Any transaction in which you use cryptocurrency that you originally received as a gift
In order to calculate the amount of your gain or loss in a virtual currency transaction, you need to know your basis in the virtual currency. If the value you receive when you dispose of the virtual currency is higher than your basis, you must report a capital gain; if the value you receive is lower than your basis, you may be able to claim a deductible capital loss.
The IRS recently issued a number of clarifications on how to determine your basis, including:
- If you use real currency to purchase cryptocurrency (for example, using U.S. dollars to purchase Bitcoin), your basis is usually the amount you paid.
- If you receive cryptocurrency in exchange for goods or services, your basis is usually the fair-market value (FMV) of the cryptocurrency at the time you received it.
- If the FMV of virtual currency you receive is not known (for example, if the virtual currency is not publicly traded), then your basis is usually the FMV of whatever property or work you traded for the cryptocurrency.
- If you receive virtual currency as a gift and later dispose of it at a gain, then your basis is equal to the gift donor’s basis, plus any tax the donor paid on the gift.
- If you receive virtual currency as a gift and later dispose of it as a loss, then your basis is the lesser of the donor’s basis and the FMV of the virtual currency when you received it.
Failure to keep detailed records of your cryptocurrency transactions can be costly. For example, if you receive virtual currency as a gift but cannot document the donor’s basis, your basis is zero. Therefore, the full value of any transaction involving that virtual currency may be taxable.
Remember also that short-term capital gains (those that occur within a year of your receipt of the cryptocurrency) are taxed as ordinary income, whereas long-term capital gains are taxed at lower rates. Therefore, it is often advantageous to hold virtual currency for more than a year before disposing of it in any fashion.