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Cryptocurrency – Understanding Virtual Currency and its Surprising Tax Implications

What is Virtual Currency

Unless you have been hiding under a rock for the last couple of years (I don’t blame you), you are probably aware of or very confused by the term, virtual currency. The entire world has been scrambling to develop applications, technology, or just a basic understanding of what virtual currency is and/or how they can incorporate it into everyday life.

According to the Internal Revenue Service, “virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”

In simpler terminology, virtual currency is considered digital money that has a real-time value that can be used for multiple applications.

Cryptocurrency

If you were one of the estimated 117 million viewers of Super Bowl LVI, you may have wondered why a floating QR code took over your tv for 60 seconds during the game.  Cryptocurrency is the reason for the retro DVD-designed ad space by a popular cryptocurrency exchange app called, Coinbase.

Cryptocurrency is a type of virtual currency that is typically decentralized and tracked by blockchain technology, also known as a digital ledger. Mainstream cryptocurrencies like Bitcoin, Ethereum, and Dogecoin are just the tip of the iceberg when it comes to cryptocurrency.  According to CoinMarketCap, more than 10,000 different cryptocurrencies are available as of February 2022.

The cryptocurrency market operates similarly to the stock exchange in a way that you can purchase crypto for a specific value one minute and sell it the very next day for a different value. Also, it is becoming more and more popular to purchase digital or real-world items with crypto, essentially selling the crypto at the current value and purchasing the item at the same time.

According to an article published by si.com, high profile WR for the Super Bowl champion LA Rams, Odell Beckham Jr. received his one-year salary in Bitcoin via CashApp.

Confused yet? If not, get ready, because this phenomenon is changing the way the world does transactions and it doesn’t look to be slowing down.

NFTs

Starting in 2015, the new idea of a unit of data stored on the blockchain that certifies a digital asset was born, thus creating one of the most trending topics besides Covid-19 stats in 2021 – non-fungible tokens, better known as NFTs. This technology not only increased revenue significantly for digital artists across the globe, but also is transforming real-world transactions such as the real estate market. Now besides just displaying your latest NFT as your Twitter account profile picture, families purchasing their forever home can use the latest NFT technology to ink the deal.

According to an article by Coindesk, a four-bedroom Gulfport, Florida home was recently purchased via auction on blockchain startup Propy’s platform for $653,000 (210 ETH). The winning bidder was awarded an NFT as proof of the home’s ownership.

Virtual Currency Question on 1040

Yes or No

IRS is continuing its effort to make taxpayers aware of the tax consequences involving virtual currency by requiring all taxpayers to answer the following question on page 1 of the 2021 Form 1040:

“At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”

This question should be answered “Yes” for virtual currency transactions that include (but not limited to):

  • The receipt of virtual currency as payment for goods or services provided
  • The receipt or transfer of virtual currency for free (without providing any consideration) that does not qualify as a bona fide gift
  • The receipt of new virtual currency as a result of mining and staking activities
  • The receipt of virtual currency as a result of a hard fork
  • An exchange of virtual currency for property, goods, or services
  • An exchange/trade of virtual currency for another virtual currency
  • A sale of virtual currency
  • Any other disposition of financial interest in virtual currency

This question should be answered “No” in the following circumstances:

  • Taxpayer did not have any transactions involving virtual currency during 2021
  • The individual’s only transactions during 2021 involved holding virtual currency in a wallet or account
  • The individual’s transactions only involved the transfer of virtual currency from one wallet or account the individual owned or controlled to another they owned or controlled
  • The individual’s only transaction(s) involving virtual currency were purchases of virtual currency for real currency, including the use of real currency electronic platforms such as PayPal or Venmo.

If an individual answers the Virtual Currency question “Yes”, their virtual currency transactions will need to be correctly reported on their 2021 federal tax return as follows:

  • On Form 8949 to figure the capital gain or loss, if the virtual currency is disposed of through a sale, exchange, or transfer
  • On Form 1040, line 1, if the individual received virtual currency as compensation for services
  • On Schedule C, if the individual received virtual currency that they held for sale to customers in a trade or business
Cryptocurrency Bitcoin

Tax Consequences of Using Virtual Currency

In 2014, the IRS issued a notice (IRS Notice 2014-21) declaring that for tax purposes, virtual currency is property, not currency or legal tender.

Therefore, for tax purposes, anytime an individual uses virtual currency to purchase goods and/or services, or converts it into cash, the IRS considers this to be a capital transaction (similar to selling a stock). The result of this transaction is a capital gain or loss which must be reported on Form 8949 (Sales and other Dispositions of Capital Assets). The transaction recorded on Form 8949 will then flow to Schedule D (Capital Gains and Losses) on the taxpayer’s federal tax return.

The following explains when a virtual currency transaction results in either ordinary income to an individual or capital gain or loss, as well as how to determine the contribution amount when virtual currency is used to make a charitable contribution:

Ordinary Income to an Individual

Receiving virtual currency is ordinary income to an individual when:

  • The individual receives virtual currency as compensation for services. When this occurs, the individual will receive a Form W-2 at the end of the year with the amount of income determined as the fair market value of the virtual currency at the date it was given to the individual as compensation.
  • The individual receives virtual currency for the sale of goods or services to customers in a trade or business. The individual will report the income on Schedule C line 1 with the dollar amount of each transaction determined as the fair market value of the virtual currency on the date of the transaction.

If the virtual currency that is received as income is not converted to cash on the day it is received, a capital transaction will occur if it is converted at a later date or is used to purchase goods and/or services.

Capital Transaction for the Individual

For tax purposes, a capital transaction occurs whenever an individual uses virtual currency to purchase goods and/or services or converts virtual currency into cash after holding it for more than a short period of time.

Each purchase or conversion is treated as a separate transaction and is required to be reported on Form 8949 (Sale and Other Dispositions of Capital Assets) which will then flow to Schedule D (Capital Gains and Losses) on the individual’s federal income tax return.

For each virtual currency transaction, the individual will either have a short-term or long-term capital gain or loss. A short-term capital gain or loss will occur if the virtual currency that was used in the transaction was held for one year or less. If it was held for more than one year, the result will be long-term capital gain or loss.

The basis of the virtual currency (purchase price or cost) used is its fair market value on the day the individual received it and the sales price is the value of the goods received, service performed, or the cash received on the date the sale, service, or conversion occurred.

Expense and Capital Gain/Loss in One Transaction

When a business uses virtual currency for goods and/or services, two transactions will occur:

  1. An expense for the value of the good(s) purchased or service received.
  2. A capital transaction for the virtual currency used for the good purchased or service received.

Making a Charitable Contribution Using Virtual Currency

An individual who donates virtual currency to a charitable organization will not recognize income, gain, or loss when making the donation.

The amount of the charitable contribution is determined based on the amount of time the individual held the virtual currency as follows:

  • If held for more than one year – Deduction is the fair market value at the time the donation was made.
  • If held for one year or less – Deduction is the lesser of the individual’s basis in the virtual currency or the virtual currency’s fair market value at the time the donation was made.

See Questions 34 and 35 of the IRS Frequently Asked Questions on Virtual Currency Transactions for more information.

See the following on the IRS website for more information:

Zac Crites

Zac Crites

Zac Crites started a career in the tax industry in 2007 with Tax Tech, Inc. (TTI) serving primarily as a driving force in training, support, and marketing for TTI. Upon the acquisition of TTI, Zac has been working for CrossLink Professional Tax Solutions (CPTS) since 2019, where he serves as a Supervisor for a team at CrossLink Tax Tech Solutions and a Digital Marketing Analyst for CPTS.
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