There has been a lot of buzz around ‘cryptocurrency’ lately, mostly due to the recently passed tax code H.R.1. So, let’s discuss its history and what crypto enthusiasts should be doing in light of the changing tax code.
What is it?
Cryptocurrency, or digital currency, is a virtual representation of value which can be used to pay for goods or services, or held for investment. Through some platforms, like Bitcoin, cryptocurrency can act like a substitute for real currency, which is called convertible currency. As convertible currency, it can purchase or be exchanged for dollars or euros, including other virtual currencies.
IRS previous rulings on virtual currency
As it started to increase in popularity, accountants, businesses and individuals alike were wondering how the IRS wanted to handle this new virtual currency. To clear things up, the IRS issued a formal notice on March 2014. Regarding federal taxes, the IRS says this:
“The sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.” – IRS Notice 2014-21.
The main take-aways from this notice are:
- The value of the cryptocurrency was to be based on the value of the U.S. dollar on the day of the transaction.
- Those who received virtual currency as payment for a good or service that they are selling, must report that income on their tax return.
- Cryptocurrency investments are to be treated like stocks or bonds – making users liable for taxable gains and eligible for taxable deductions on losses.
- Cryptocurrency was to be recognized as “property”.
This last point is perhaps the most important. Even though the IRS outlined tax triggering events, because cryptocurrency was to be considered property, crypto users could now take advantage of a popular property tax loophole.
1031 tax loophole
In short, a 1031 exchange allows a taxpayer to swap an investment property for another “like-kind” property without having to pay capital gains tax. A “like-kind” property is defined as property that is of the same nature, character or class.
For Bitcoin or Ethereum users, this loophole allowed them to swap an asset – like digital currency – for a similar asset (or digital currency) without having to pay taxes on any income earned from the transaction.
With thousand-percent gains, cryptocurrency was on its way to becoming the virtual Wall Street. What users didn’t realize was how greatly this new industry would be impacted by the GOP’s tax reform bill.
How H.R.1 Affects Cryptocurrency
The new tax bill – Tax Cuts and Jobs Act – effectively eliminates like-kind exchanges (also called 1031 exchanges) for cryptocurrency traders, by changing its language from “property” to “real property”. Under the new law, only tangible assets, like houses, can qualify for a like-kind exchange. This effectively makes all cryptocurrency transactions taxable events. Going forward after December 31, 2017, traders will need track gains or losses on all cryptocurrency exchanges.
When it comes to gains: To determine gains, a user must keep track of basis – that is, the original price the user paid for the virtual currency. For tracking, Forbes recommends keeping a separate online wallet for each cryptocurrency purchase.
When it comes to losses: Some, but not all losses may qualify for a tax deduction. Losses that are eligible for a tax deduction are only trade or business transactions which are entered into for profit – aka an investment. So, if Tracey uses her bitcoin to buy some merchandize from an online retailer and she notes a loss of $85, she cannot deduct that loss because it is considered to be a personal loss.
A cryptocurrency tax attorney can help users in determining taxable gains and deductible losses. For more information call us at 303-688-0944.