Cryptocurrency & Federal Income Taxes
I help people who are interested in minimizing their cryptocurrency tax liability while remaining in full compliance with Federal and state tax law.
The original version of this paragraph was written in October 2017, when BTC was around $6,000, and ETH $300. It was a simpler time. :-) I had expected cryptocurrency prices to continue their volatility, but I had no idea of the wild ride to follow.
Some of you took big gains off the table (sales to fiat) in 2017 and the first quarter of 2018. Some of you had crypto-to-crypto sales in 2018 and have enormous realized gains and (quite possibly) enormous unrealized losses.
What to do? Crypto sales are tax reporting events and taxable events, even if you don't exchange crypto for fiat currency.
After the March 2000 NASDAQ crash, we knew that Internet businesses were for real and were going to be around for a long long time. Your cryptocurrency holdings may be the equivalent of Amazon.com in 2000...or of eToys.com. Or some of each.
Here's what we know now, based on the IRS's limited guidance on cryptocurrency. (This is an informal introduction, not professional guidance.)
Notice 2014-21, Then Silence
IRS has been largely silent since Notice 2014-21, which remains the primary guidance for the taxation of cryptocurrency transactions ("virtual currency" in IRS-speak).
Mining is Ordinary Income and is Subject to Self-Employment Taxes
Per Notice 2014-21, the fair market value of cryptocurrency mined is business income on the date of its mining; the related ordinary and necessary business expenses (electricity, depreciation, Section 179 elections) offset that business income. Bitcoin miners are subject to self-emplyment taxes, just as self-employed coal miners are.
If your "other" earned income is above the 2018 Social Security cap of $128,400, then you'll probably just be paying 2.9% to 3.8% in additional Medicare tax.
However, if your "other" earned income is substantially less than $128,400, be prepared for sticker shock on your tax return. Proper tax planning can mitigate the pain.
Gains and Losses on Cryptocurrency Trades
Again following Notice 2014-21, these gains and losses are similar in most respects to gains and losses on sales of securities. Day traders in particular should note that the wash sale rules may apply.
How to calculate basis on gains? LIFO (last-in, first-out) basis had obvious advantages in a rapidly appreciating market, but is less appealing for 2018 investmemts. Average cost basis will be easier to administer (no need to worry about "LIFO layers" ) and, in some cases, yield similar results. But average cost basis is rarely the optimal method.
Transferring coins from one wallet you own to another wallet you own is not a trade. Of course, the basis of the transferred coins remains unchanged.
Accounting for these gains and losses is a major headache, especially if you are working with exported CSV files from multiple sources. There are good cloud-based software solutions. I can help you choose the solution that fits your needs and your budget.
Once upon a time, there was BTC. Then holders of BTC "magically" received BCH. Was this an "accession to wealth" taxable as ordinary income? Here's one opinion. But this otherwise reasonable analysis overlooks one very important fact: if BTC were already perfect, then BCH wouldn't have been created. To me, the Glenshaw Glass test seems wrong .
Nor is receiving BCH is analogous to finding an envelope stuffed with thousands of dollars in a used piano: it's the natural consequence of holding BTC as of a certain date. The darn fork was created for a reason!
Does this mean you can simply ignore the bitcoin fork? I didn't say that, either.
Absent IRS guidance, I have my own opinion as to how to properly treat the fork for tax reporting purposes. I believe that my approach is in full compliance with the Internal Revenue Code. I don't guarantee that IRS will agree with me, however.
Like-Kind Exchanges in Tax Year 2017?
Are Section 1031 exchanges of one "convertible virtual currency" (IRS's term of art in Notice 2014-21) for another permissible? We can trade one piece of real estate for another of equal or greater value: as long as we don't receive fiat currency or other non-like-kind property ("boot") in return. In tax year 2017, did this work for like-kind exchanges of cryptocurrency, too?
In certain cases, perhaps.
But heed the wise words of caution in Robert A. Green's Cryptocurrency Traders Risk IRS Trouble with Like-Kind Exchanges. Perhaps Mr. Green's counsel is a bit too cautious. Based on my reading of the Internal Revenue Code, I believe that certain 2017 like-kind exchanges of convertible virtual currency would pass IRS muster.
Can I guarantee that IRS will agree with me? I cannot. And even if one prevails, one may not be able to do so without first visiting Tax Court.
Both form and substance count!
In any case, it's clear that all 2017 realized gains on exchanges of cryptocurrency must be reported on one's 2017 tax return, even if these gains are not recognized as current-year taxable events.
As of January 1, 2018, recognition of capital gains on like-kind exchanges of personal property may no longer be deferred under Section 1031. My condolences.
Foreign Income: General Painful Observation
Sorry, US citizens and permanent residents are subject to taxes on worldwide income.
If your income is sourced to the fictitious nation of Freedonia, you will generally be subject to Freedonian income taxes. (Whether your income is US-source or foreign-source may be determined by the US-Freedonian income tax treaty.) You will generally receive a credit for foreign taxes paid to Freedonia in the USA, to the extent that the US rate is higher than the Freedonian rate. But if you've paid 10% to Freedonia and your Federal marginal rate is 37%, then (speaking very roughly) you'll probably owe 27% to the Feds.
Again, sorry about that.
Don't forget to make foreign financial disclosures where required: pay particular attention to the requirements of FinCEN Form 114 and IRS Form 8938. For example, if one had an account in the equally fictitious "Son of Mt. Gox" (a good monster-movie title?), then one would normally be required to disclose that one holds an offshore financial interest in Japan. The level of disclosure would generally depend on the peak fair market value of your investment during the reporting year.
As Stephen Sondheim observed, “Nobody knows in America Puerto Rico’s in America.” Interested in Act 22? It’s not for everybody, but I do have professional contacts in San Juan.
Death and Taxes (and More Pleasant Things)
I have reason to suspect that there may be investors who have passed away in the past year with a taxable cryptocurrency estate ($11.18 million in 2018). Even if the deceased's net worth was substantially less, the heirs might substantially benefit from filing an estate tax return to report stepped-up basis and dramatically reduce future capital gains. Even when a widow(er) inherits his or her spouse's estate tax-free, there still may be enormous benefits to filing an estate tax return for the deceased.
Dying with too much crypto is no fun. Enjoy life: give some away to your loved ones! Gifts in excess of $15,000 per giftee per year count against the gift-giver's lifetime exclusion. Are you contemplating a giving or receiving a major gift of cryptocurrency? You may need to do some tax planning to maximize the effectiveness of the gift.
I am not an estate tax attorney, nor am I a CPA who specializes in estate tax or gift tax matters. But I have worked in conjunction with specialists on gift and estate tax matters, including cryptocurrency matters.
Coming in from the Cold
Reporting cryptocurrency transactions is confusing. Perhaps you did not report them correctly in a prior year? I am happy to help taxpayers come into compliance with Federal and state law.
The lack of clear guidance from the IRS does not relieve you of the obligation to report and pay taxes on "income from whatever source derived." Once the noncompliant taxapayer comes into compliance by reporting overlooked prior-year income, and paying back taxes, penalty, and interest, that taxpayer may have also established that cryptocurrency held today qualifies for long-term capital gain treatment.
If one has failed to report more than (say) $500,000 in prior year cryptocurrency income, then one may wish to speak to a tax attorney regarding a voluntary disclosure arrangement. I am not a tax attorney. If you "have a friend" in this situation, I could help your friend find one.
If, however, one has failed to report less than $50,000 in prior year cryptocurrency income, then it may make sense to simply amend the relevant returns and self-assess the various penalties and interest. IRS voluntary disclosure programs may well be overkill for "small fry." This latter course is not risk-free, but IRS is generally disinclined to throw the book at taxpayers making full voluntary disclosures of past errors and omissions.
Are you an arbitrage trader buying and selling on multiple exchanges all day long? You are my hero! There are incredible opportunities in the current market.
It would be a shame to pay taxes on the top marginal rate for the first eleven months of 2018, then get wiped out by the (hypothetical) Great Crypto Crash of December 2018. To add insult to injury, without proper planning, you would not be able to pair your losses against your income. If you qualify, a mark-to-market election under IRC Section 475(f) may make sense for you!
The Highest and Best Use of Appreciated Assets
If you are charitably inclined and you have large unrealized gains, consider donating virtual currency to your place of worship or your favorite 501(c)(3) nonprofit organizations. (In the process, you may also become cryptocurrency evangelists: the pastor at Sleepy Smalltown Church and the executive director of your local cat shelter will need to open Coinbase accounts!) You must gift the cryptocurrency without selling: if you sell and gift the proceeds, the sale is a taxable event.