Cryptocurrency – Tax Treatment
I spoke with an accountant last week who mentioned how the IRS ruled to treat cryptocurrencies for tax purposes, so I did some research.
Turns out, the IRS tax treatment of virtual currencies as a capital asset is a bit convoluted… in that every purchase you make (where you sell virtual currency), you have to record the value of the currency at that moment and compare that to your cost basis (when you bought the virtual currency). If there was a gain on the cryptocurrency while you held it, you have a taxable event.
Let’s look at an example:
- Buy 1 Bitcoin for $10,000. You get 0.0001 Bitcoins.
- Wait a month. Good news. Bitcoin is now trading at $20,000 per coin.
- Buy a $4 hot dog using Bitcoin. But the hot dog only costs you half of the Bitcoin it would have cost a month ago, when you purchased the Bitcoin.
- According to the IRS, you have captured a $2 capital gain for tax purposes with this transaction (because you purchased a $4 hot dog, but it only cost you $2 due to the increase in the value of the Bitcoin).
- You record your short-term capital gain, so you can report it to the IRS when you file your taxes.
- The hot dog vendor records his $4 cost basis in his newly acquired 0.0002 Bitcoins.
With this tax treatment, every single transaction where you spend Bitcoin has a potential taxable event on the gain of the coin while you held it. The default IRS accounting method is First-In-First-Out (FIFO), like trading stocks. Can you imagine trying to keep track of the cost basis at the exact moment for every transaction for all the fractional Bitcoins you spend? I guess almost no one will report this… but this tax treatment will likely deter businesses from broadly adopting virtual currencies.
But wait, there’s an interesting twist – if the Bitcoin had gone down while you held it in your virtual wallet, you may not be able to record a loss for tax purposes. You’re required to record taxable gains, but not losses? Yes. Maybe. What?
The determining factor is whether you are holding Bitcoin as an investor or as a consumer.
- If you hold Bitcoin as a consumer, you do NOT get to record losses for tax purposes.
- If you hold Bitcoin as an investor, you DO get to record taxable losses… even if you “happen” to exit your Bitcoin investment by buying merchandise at an online retailer.
- In both cases (consumer or investor), you must report any taxable gains.
The twist is that the tax treatment is dependent on your intent. Yeah, it’s opaque.