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.
As I write in October 2017, BTC is within striking distance of $6,000, and ETH of $300. (UPDATE 11/17/17: well, that's out of date!) If you're reading this, you may have significant unrealized gains in cryptocurrency.
What to do? It's rational to take of your unrealized gains off the table, but doing so is almost always a reportable event. In the general case, taking your gains off the table is also a taxable event, even if you don't exchange crypto for fiat currency..
In 1999, we knew that Internet businesses were for real and were going to be around for a long long time.
And yet NASDAQ crashed in March 2000.
Your cryptocurrency holdings may be the equivalent of Amazon.com in 1999...or of eToys.com in 1999. Or some of each.
Even if one is hyper-bullish, it's good portfolio management to hold multiple virtual currencies. Trading from one cryptocurrency to another is always a reportable event, and generally a taxable event.
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
How the heck does the IRS tax Bitcoin, Ethereum, Litecoin, or any of the ICO new kids on the block? 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 on the date of its mining is business income; the related ordinary and necessary business expenses are business expenses. Bitcoin miners are subject to self-emplyment taxes, just as self-employed coal miners are.
If your "other" earned income is above the 2017 Social Security cap of $127,200, 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 $127,200, 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 apply.
How to calculate basis on gains? LIFO (last-in, first-out) basis has obvious advantages in a rapidly appreciated market. Average cost basis is easy to administer and, in many cases, may yield similar results.
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.
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 . Receiving BCH is not 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 report the fork. I believe my approach is in full compliance with the Internal Revenue Code. I don't guarantee that IRS will agree with me, however.
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. Does this work for like-kind exchanges of cryptocurrency, too?
As of September 2017, I believe that like-kind exchanges may be possible in certain cases.
But heed these wise words of caution: 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 like-kind exchanges of convertible virtual currency will 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 realized gains on exchanges of cryptocurrency must be reported on one's tax return, even if these gains are not recognized as current-year taxable events.
(This Section 1031 loophole may be closed very soon: see the final sentence in the "Pending Legislation" section below.)
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 39.6%, then (speaking very roughly) you'll probably owe 29.6% to the Feds.
Again, sorry about that.
Don't forget to make foreign financial disclosures where required: 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 during the reporting year.
Several people have approached me about setting up multinational structures. I am not a tax attorney, and complex international taxation issues are not in my wheelhouse.
But if the complex foreign structure has already been established, and you're interested in annual reporting and compliance, I may be able to help.
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 estabished 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. I could be hired by a tax attorney who is in turn hir
- 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.
I have no idea (as of Nov. 16, 2017) whether Congress will get a tax bill through. From what I've seen, I would suggest that the 2018 capital gains rate will be somewhere between 0% and 5% lower than today's rates. (Larger reductions would probably require ACA repeal, and as I write, that scenario seems unlikely to be effective as of January 2018.)
It's complicated, and my crystal ball is broken. But various scenarios can be modeled based on drafts of the Senate bill and the House bill.
Rumor has it that the Senate bill would remove ALL like-kind exchanges (Section 1031) of personal property.
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