The Internal Revenue Service (IRS) has moved the cryptocurrency question from Schedule 1 of Form 1040 to Page 1 of Form 1040, right below the name and address fields further highlighting the IRS’s focus on cryptocurrency transactions. The IRS is asking taxpayers to indicate whether they have engaged in a transaction with cryptocurrency, including whether they have received, sold, sent, exchanged, or otherwise acquired “any financial interest” in virtual currency (digital currency and cryptocurrency).
Cryptocurrency refers to a type of virtual currency that allow participants to exchange encrypted property on a distributed ledger or “blockchain.” Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places at the same time, with no central data store or administration functionality. While cryptocurrency was long synonymous with Bitcoin, the market has exploded in recent years and cryptocurrency now includes numerous types of coins which are used for many different purposes.
Almost seven years ago, the IRS issued its first and, still, one of only two, formal pieces of guidance on cryptocurrency. Notice 2014-21 describes the application of general tax principles to virtual currency transactions. Virtual currency is defined in the Notice as a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value that in some environments operates like real currency but does not have legal tender status in any jurisdiction.
The Notice includes frequently asked questions, and states that virtual currency is treated as property for federal tax purposes, with the result that general tax principles applicable to property transactions also apply to cryptocurrency transactions. The treatment of cryptocurrency as property is discussed in more detail below.
Reporting requirement for individual income tax returns (Form 1040)
In its instructions released in early January this year, the IRS clarified that a transaction involving virtual currency includes, but is not limited to:
- The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or following a hard fork (discussed below);
- An exchange of virtual currency for goods or services;
- A sale of virtual currency;
- An exchange of virtual currency for other property, including for another virtual currency; and
- A disposition of financial interest in virtual currency.
The instructions also indicate that the transfer of virtual currency from one wallet or account that an individual owns to another that the individual also owns or controls is not a transaction for purposes of the cryptocurrency question on page 1 of Form 1040.
Although not law, the current frequently asked questions posted by the Internal Revenue Service also indicate that a transfer of virtual currency from a wallet, address, or account belonging to an individual, to another wallet, address, or account that also belongs to that same individual, is a non-taxable event, even if the individual receives an information return from an exchange or platform as a result of the transfer.
Answering the question
Although there is still quite a bit of uncertainty around this question, here is a helpful chart explaining how to answer:
Cryptocurrency as property
Although the IRS has announced that transactions in cryptocurrency will be taxed like transactions in property, it has not addressed the question of how to classify cryptocurrency within that general category. For example, there are cases where it might be appropriate to characterize cryptocurrency as a commodity, a security, or a financial contract. It could also be appropriate in some circumstances (although the IRS has not weighed in on this topic) to tax cryptocurrency as an integral part of a business differently from cryptocurrency held for another purpose, while cryptocurrency that is regularly traded should, perhaps, receive different tax treatment from that held as a long-term investment. Other possible characterizations include securities loans, notional principal contracts, and leases.
Note that other federal agencies have taken different approaches to the legal classification of cryptocurrency. The Commodity Futures Trading Commission treats Bitcoin and Ether as commodities, while the SEC treats some tokens and coins offered in initial coin offerings as securities. Although the IRS generally defers to the CFTC for the definition of commodity, it has not provided taxpayers with guidance as to whether that principle would apply to cryptocurrency. Its guidance has been limited to digital currency convertible to fiat currency that functions as a substitute for cash, leaving taxpayers with no guidance on the proper tax treatment of tokens used to access services, blockchain that does more than function as digital money, or coins that represent a profits interest in a company.
Reporting requirement for foreign bank and financial accounts (FBAR Form 114)
Currently, the FBAR regulations do not define a foreign account holding virtual currency as a type of reportable account. Therefore, at this time, a foreign account holding virtual currency is not reportable on the FBAR. However, FinCEN announced in Notice 2020-2 that it intends to amend the regulations implementing the Bank Secrecy Act (BSA) regarding FBAR reports to include virtual currency as a type of reportable account.
Additional reporting requirements under FinCEN
The FinCEN in its publication dated December 23, 2020, proposed new reporting, recordkeeping, customer identity verification, and counterparty identification requirements for certain transactions involving convertible virtual currency (CVC) and digital assets with legal tender status (LTDAs). The most consequential aspect of the proposed rule would be the requirement for banks and money services businesses (MSBs) to collect, among other information, a name and physical address associated with any un-hosted-wallet counterparties of their customers for a single CVC/LTDA transaction involving a value greater than $3,000 or a group of transactions exceeding $10,000 in a 24-hour period.
Under the new rule, if a customer sends or receives more than $10,000 in CVC/LTDA over a 24-hour period to, or from, a covered wallet, then the bank or MSB would be required to verify the identity of its customer and file a report with FinCEN containing information including the name and physical address of the counterparty.
FinCEN states that this would be analogous to the existing currency transaction reporting (CTR) requirement, and the rule creates a similar prohibition on structuring. In addition, if a customer sends or receives more than $3,000 in CVC/LTDA to, or from, a covered wallet, then the bank or MSB would be required to verify the identity of its customer and to keep records of the customer’s transaction and counterparty, including the name and physical address of each counterparty.
Hard forks and FAQs
In 2019, the IRS issued a revenue ruling governing the tax treatment of hard forks, along with a series of Frequently Asked Questions that address other cryptocurrency-related issues. Rev. Rul. 2019-24 addresses the tax consequences of two types of transactions: hard forks (for some of which the IRS says the taxpayer doesn’t receive a new unit of cryptocurrency) and airdrops following a hard fork.
A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. A hard fork may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. An airdrop is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple individuals.
The revenue ruling says that because the airdrop following a hard fork results in the distribution of units of the new cryptocurrency, it represents an accession to wealth and constitutes a recognition event for tax purposes, when the new cryptocurrency is recorded on the new ledger.
Among the questions addressed in the FAQs are how to determine basis in virtual currency purchased with real currency, how to calculate gain or loss when exchanging virtual currency for other property, and how to calculate the charitable contribution deduction when donating virtual currency.
Please consult your Mazars LLP professional for additional information.
Published on February 15, 2021
Authored by Payal Parikh with Ivins, Phillips & Barker, Chtd.