Many taxpayers realized significant gains from the disposition of cryptocurrencies in 2017, and as tax season approaches, these taxpayers must compile accounting reports, review the latest tax guidance, and determine how to correctly report their transactions to the IRS.
Coinbase has a new online tax report:
In the summer of 2017, the IRS narrowed its summons against Coinbase, the largest U.S.-based coin exchange, to retrieve information on large trades and other transactions to find unreported income. At the very end of 2017, Coinbase added tax reporting of capital gains and losses using first in, first out (FIFO), which pleases the IRS and helps taxpayers report their transactions since coin trades are currently not reported on Form 1099-B.
Capital gains and losses:
The IRS classifies cryptocurrencies as “intangible property” (a capital asset) because they are not sovereign government-issued money. If you sold, exchanged, or spent a cryptocurrency in 2017, you need to calculate a capital gain or loss on each transaction, including coin-to-currency trades, coin-to-coin trades, and purchases of goods or services using a coin.
Coin-to-currency trades and mining income:
Coin-to-currency trades (e.g., the sale of a coin for U.S. dollars) should be reported as a capital gain or loss on Form 8949 just like any stock trade. For example, if you purchased one Bitcoin for $500 in 2016, held it for over a year, and sold it for $10,500 in 2017, then you need to report a long-term capital gain of $10,000, which would be taxed at capital gains tax rates (up to 23.8% in 2017 and 2018). If you held the coin for one year or less before selling it for a gain, you would need to report a short-term capital gain, which would be taxed at ordinary income tax rates (up to 39.6% in 2017 or 37% in 2018). Although capital losses offset capital gains, net capital losses are capped at $3,000 per year, so net capital losses in excess of $3,000 are carried forward to the subsequent tax year and cannot be carried back to a prior tax year.
Certain coins can be obtained by “mining,” which requires significant computing power. When a coin miner receives a coin for his or her mining services, he or she should report business income based on the value of the coin he or she received.
Imputed income:
Although coin-to-currency trades and mining income seem straightforward from a tax reporting perspective, most other coin transactions are more complex. Coin-to-coin trades, hard forks (chain splits), and the exchange of a coin for goods or services require the taxpayer to “impute” a sale or exchange transaction to report a capital gain or loss.
Coin-to-coin trades:
Many coin traders actively trade one type of coin for another type of coin, and some of these coin traders take the ill-conceived position that they can defer capital gains on coin-to-coin trades by inappropriately classifying them as Section 1031 “like-kind” exchanges. A like-kind exchange is a transaction or series of transactions that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset. As of January 2018, the IRS has not yet provided guidance on this matter, but many experienced tax practitioners believe coin-to-coin trades made on coin exchanges do not qualify as like-kind exchanges because they fail one or both of the primary requirements for a like-kind exchange (and both are required). First, one type of coin is not like-kind property with another type of coin. Second, coin-to-coin trades executed on coin exchanges do not constitute a direct two-party exchange, and coin exchanges are not qualified intermediaries in a multi-party exchange.
Atomic swaps or atomic cross-chain trading started in August 2017. The new technology allows a direct two-party exchange, bypassing coin exchanges. That may meet one requirement for a like-kind exchange, but the coins must also be a like-kind property for the gain deferral, which is a position that will likely be scrutinized by the IRS.
The effect of the new tax law on coin traders:
Beginning in 2018, the new tax law limits like-kind exchanges to real property. This means taxpayers may no longer utilize like-kind exchanges for artwork, collectibles, and other tangible and intangible property, including cryptocurrencies.
The new tax law created Section 199A, which provides a 20% deduction of qualified business income (QBI) for passthrough entities (S corporations, partnerships, LLCs, and sole proprietorships). The 20% deduction of QBI is subject to numerous thresholds and limitations. Unfortunately, a coin trader likely does not qualify for the deduction because he or she has capital gains income, which is excluded from QBI. On the other hand, a securities trader with trader tax status can elect Section 475 mark-to-market ordinary income, which is included in QBI.
Taxpayers can deduct coin fees and other expenses that they incurred in 2017, but most will not be able to deduct such fees and expenses beginning in 2018 because the new tax law suspends the deduction for investment expenses.
Coin hard forks (chain-splits):
Bitcoin had a hard fork in its blockchain on August 1, 2017, dividing into two separate coins: Bitcoin and Bitcoin Cash. Each holder of a unit of Bitcoin was entitled to arrange receipt of a unit of Bitcoin Cash. Some Bitcoin holders did not gain immediate access to sell their units of Bitcoin Cash, so they believe they should be able to defer income on the fork transaction until they obtained access to sell their units of Bitcoin Cash or until they outright sell their units of Bitcoin Cash. Coinbase did not support Bitcoin Cash when it forked, but it did add the units of Bitcoin Cash to the accounts of the rightful holders in late 2017.
It is reasonable that coin traders should not have to report taxable income on a hard fork until the new coin is time-stamped as a ledger entry, sending the coins to new outputs in the blockchain. Facts and circumstances on hard forks vary widely. An “old fork” could die out if miners collectively switch over to the new blockchain and abandon the old coin. Bitcoin Cash successfully forked from Bitcoin; both trade at higher values today than on the fork date. Hard forks frequently happen, and their initial fair market value varies significantly across coin exchanges.
Some tax practitioners believe holders of Bitcoin Cash had dominion and control over the new coin sometime in 2017, and they should recognize ordinary income on receiving it.
Cryptocurrency accounting:
Cryptocurrency tax reporting is complex and voluminous. Consider two cryptocurrency accounting solutions: Bitcoin.Tax and CoinTracking.Info.
The most common approach is the use of the FIFO accounting method for cost-basis on cryptocurrency capital gain and loss transactions. The IRS has not yet stated if it will permit other accounting methods, like the specific identification method allowed for securities. Even if the IRS approves the specific identification method, compliance with the requirement for contemporaneously written instructions to the coin exchange does not seem possible. It is unlikely that a coin exchange would confirm and execute a specific identification.
Because the IRS classifies cryptocurrencies as intangible property, wash-sale loss rules likely do not apply. Traders with the trader tax status using Section 475 ordinary gain or loss on securities and/or commodities (Section 1256 contracts) may not use Section 475 on a cryptocurrency because a cryptocurrency is not a security or a commodity in the eyes of the IRS.
What you should do:
If you sold, exchanged, or spent a cryptocurrency in 2017, you need to calculate capital gains or losses on your transactions using the FIFO accounting method. And keep in mind that capital gain/loss treatment applies to not only coin-to-currency trades but also to coin-to-coin trades and purchases of goods or services using a coin.
Given the current lack of IRS guidance on cryptocurrencies, you should file an extension and pay any tax due by April 17, 2018. Hopefully, the IRS will provide some answers before the extended due date of October 15, 2018. You should consult your tax advisor in the meantime. » Contact us today.
About the Author
Matthew Weber, CPA, MAcc, Director
Tax, Financial Services Sector, Hospitality
Matthew Weber is a Director at KROST. He has been with the firm’s tax practice since July 2015 and has worked in public accounting since 2010. Before joining the firm, Matthew was a Tax Manager at PricewaterhouseCoopers in Los Angeles. Matthew’s areas of expertise include federal and multi-state tax compliance and consulting for individuals, corporations, and partnerships. » Full Bio