Cryptocurrency Tax FAQ (2018) – IRS Virtual Currency Tax Basics
Cryptocurrency Tax FAQ (2018) – IRS Tax Basics | What You Need to Know
Even though cryptocurrency is complicated, and taxes related to cryptocurrency are even more complicated, in the end, from an IRS perspective — cryptocurrency is property, and taxed accordingly.
And, depending on how you received the cryptocurrency, how long you held it, and what the character of the cryptocurrency was in your possession, you are taxed accordingly.
The foundation for the rules and regulations involving cryptocurrency are still being laid, but the following is a summary of the basics involving how cryptocurrency should be taxed and may be recorded.
Please note, this is a basic breakdown of cryptocurrency FAQ.
This summary is not intended to be used as a guide for you in preparing your taxes, since each person’s facts and circumstances are different, and your tax situation may include issues not contained within this Cryptocurrency Tax summary.
Do I Pay Tax When I Purchase Cryptocurrency?
No. cryptocurrency is considered property. When a person purchases property they do not pay tax because the purchase price of property is not a taxable event.
For example, last week you purchased a home for $300,000. You are not taxed on the purchase of the home, because it is not a taxable event.
The Purchase Date and Value of Cryptocurrency is Important
The date you purchased cryptocurrency (and fees you paid), will typically form the basis of your “property” and is a very important value. This is called your “basis.”
That is because at a later date, when you sell or exchange the cryptocurrency, the basis will serve as the purchase/acquisition price — and will help determine what taxes you a may owe to the IRS
What Happens When You Sell Cryptocurrency?
When you sell cryptocurrency, you have engaged in a taxable event. At the most basic level, you purchased something previously, and now you want to sell the property – hopefully for profit, which is considered Capital Gain (excluding inventory).
Example of a Cryptocurrency Sale and Tax
David purchased $25,000 of Bitcoin on January 1, 2017, and sold it on December 15, 2017 for $30,000. In other words, David purchased something for $25,000, and then sold it for $30,000 – he made $5000, and the IRS wants to tax David on his $5,000 profit.
Here’s how it works:
Short-Term Capital Gain
Since David purchased and sold Bitcoin in the same year, he held the cryptocurrency for less than a 12-months and it is considered a short-term capital gain.
A short-term capital gain is taxed at the same tax rate as regular income. Therefore, there is no special tax credit or treatment for short-term sales of a property (exclusions, exemptions, and limitations permitting)
Long-Term Capital Gain
Referring to the same example from above, instead of selling the Bitcoin on December 15, 2017, he sold it on February 8, 2018. This changes the nature of the cryptocurrency sale. That is because more than 12-months has passed since David purchased the Bitcoin.
Therefore, David’s sale will be considered a long-term capital gain. The reason why this is important, is because long-term capital gain receives beneficial tax treatment.
Long-term capital gains has a preferred tax rate. The tax rate for long-term capital gains is 15% unless a person falls into the top tax bracket, in which the tax rate jumps to 20%.
**Long-term capital gains rules change constantly, so it’s important to keep up with the rules in the year you sold it.
Short-Term vs. Long-Term Capital Gains example
Michelle and David each earn $800,000 a year and are both in the top tax bracket. If David and Michelle each purchased cryptocurrency for $30,000 and each sold it for $100,000, here is how the different situations tax situations will play out:
David’s Short Term Gain
David would have a $70,000 dollars again, that will be taxed as ordinary income tax rate, and his net effective tax rate would be somewhere between 35 to 40%. (about $25,000)
Michelle’s Long Term Gain
Michelle has a $70,000 that will be taxed at 20%.($14,000). If Michelle was not in the top tax bracket, it would only be taxed at 15% ($10,500).
If a person receives cryptocurrency as a result of employment, then the cryptocurrency value is determined on the day it is received and Income taxes must be paid.
In other words, if your employer paid you $400,000, but paid you in cryptocurrency instead of a check or cash, you still owe income tax that you would have otherwise had to pay if you had receive the money via regular currency – and you would have to pay any potential social security tax, NIIT, etc.
The idea is this: The IRS is not going to let you or your employer circumvent the tax rules to avoid paying tax, just because you received cash equivalent instead of actual cash.
From a baseline perspective — you work, and as a result of your work you were paid, and now the IRS wants its cut.
Your basis in the future sale of the cryptocurrency at a future time would be $400,000.
Exchanges in general can be confusing when it comes to the taxation portion of the exchange, so we are going to do our best to keep it very simple, using this example:
- Jennifer purchased Bitcoin for $10,000 and is now worth $20,000.
- Peter purchased Litecoin for $5,000 and is now worth $17,000.
For one reason or another Jennifer wants to Exchange her bitcoin for Peters Litecoin.
Jennifer: Jennifer has a basis $10,000. She is receiving Peter’s cryptocurrency for $17,000, which is the current market value. Jennifer has a gain of $7,000 of which she will pay tax on.
In the future, when Jennifer wants to sell her cryptocurrency, her new basis would be $17,000 instead of $10,000 because she paid tax on the full value.
Peter: Peter has a basis of $5,000 in the Litecoin. He is receiving cryptocurrency worth $20,000. Therefore, Peter has a gain of $15,000, which he will also pay tax on.
In the future, if he wants to sell cryptocurrency, his new basis will be $20,000.
In other words, when you exchange one piece of property for another, you receive the property at the current market value. So, if you received a piece of property which is more valuable than the property you have, you pay capital gain tax (usually) on the gain.
You determine the tax by subtracting the cost of the purchase of the property from the market value of the property you received, to determine your gain amount – and you pay tax on the gain amount.
You Received Cryptocurrency as a Gift
If you receive cryptocurrency as a gift, the typical tax rule is that you receive the carryover basis, which will serve as the basis for your crypto currency.
For example, your grandma purchased cryptocurrency a few years back for $20,000. Since your grandma spends her days researching cryptocurrency (and playing mahjong) she believes her investment is going to increase in value.
Your grandma was correct, because now it’s worth $400,000. She gives you the cryptocurrency and tells you to go enjoy yourself.
You decide you want to buy a house, but they do not accept Cryptocurrency as legal tender, so you sell the crypto first. Do you receive $400,000 tax-free, since that is the Fair Market Value on the date you received it?
…. Unfortunately, no. When you receive the gift from your grandma, you have to take it at that value she purchased it for, which is $20,000 – which also means you have a $380,000 gain on the exchange. (aka Carry-Over Basis)
You Received Cryptocurrency as an Inheritance (Step-up)
Unfortunately, your sweet grandma passed away before she had a chance to give you the gift. But, she was smart, she had a will, and she left you her cryptocurrency in the will.
Under estate tax rules, you receive the market value of the property on the date your grandma passed aka (Stepped-Up Basis).
Therefore, the value of the cryptocurrency you receive is now $400,000, so when you sell the Crypto for $400,000, you do not pay any tax.
1031 and Cryptocurrency
A 1031 exchange is a way to defer tax. For example, you have a rental property that you purchased for $100,000 that is now worth $1,000,000.
You don’t want to sell the property and pay tax, so you would rather shift the investment into a new rental property or something similar (since you are relocating)
You execute a 1031 exchange (which has very specific timing rules and holding requirements) and absent any boot (usually cash or mortgage payoff in addition to the property) you receive a new property, while maintaining the same basis ($100,000) and it is not considered a sale, so that you do not have to pay Capital gains tax at the time.
**Unfortunately, at this time1031 rules do not apply to cryptocurrency for exchanges for coins in 2018 and subsequent (e.g., when filing your 2017 tax return in 2018 regarding prior exchanges, there may be room for debate, but most likely not for exchanges made in 2018 going forward)
Selling Cryptocurrency as inventory is complex and beyond the scope of this article (LIFO, FIFO, COGS, etc.)
If you knowingly traded or sold crypt currency, and intentionally avoid paying tax, or reporting the sales or exchanges on a Schedule D/Form 8949, you may find yourself in hot water.
Most, if not all crypto-exchanges track and report the information, and will provide it to the IRS – whether they want to or not.
In fact, even Coinbase one of the largest (if not the largest) exchange lost its fight against the IRS, and has to disclose the names of many of it clients.
Since cryptocurrency has been dubbed “the new Swiss bank account,” and the IRS refuses to knowledge cryptocurrency as currency, there is a high likelihood that the IRS will take a heavy hand against anybody believe isn’t only evading tax and reporting.
Getting Into Offshore or Domestic Tax Compliance
Depending on the location of your cryptocurrency and issues regarding your non-compliance, you may consider entering either the Offshore or Domestic Voluntary Disclosure Program.
Offshore Voluntary Disclosure
4 Types of IRS Offshore Voluntary Disclosure Programs
There are typically four types of IRS Offshore Voluntary Disclosure programs, and they include:
- Offshore Voluntary Disclosure Program (OVDP)
- Streamlined Domestic Offshore Procedures (SDOP)
- Streamlined Foreign Offshore Procedures (SFOP)
- Reasonable Cause (RC)
IRS Voluntary Disclosure of Offshore Accounts
Offshore Voluntary Disclosure Tax law is very complex. There are many aspects that go into any particular tax calculation, including the legal status, marital status, business status and residence status of the taxpayer.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that for one or more years, you were required to file a U.S. tax return, FBAR or other International Informational Return and you did not do so timely, then you are out of compliance.
Common Un-filed IRS International Tax Forms
Common un-filed international tax forms, include:
- 1040 (Tax Returns)
- Schedule B (Ownership or Signature Authority over Foreign Accounts)
- FBAR (FinCEN 114)
- FATCA (Form 8938)
- Form 3520 (Gift from Foreign Person)
- Form 5471 (Foreign Corporations)
- Form 8621 (Foreign Investments, aka PFIC)
- Form 8865 (Foreign Partnership)
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to IRS Offshore Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.”
It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts.
The Devil is in the Details
If you do have money offshore, then it is very important to ensure that the money has been properly reported to the U.S. government. In addition, it is also very important to ensure that if you are earning any foreign income from that offshore money, that the earnings are being reported on your U.S. tax return.
It does not matter whether your money is in a country that does not tax a particular category of income (for example, many Asian countries do not tax passive income). It also does not matter if you are a dual citizen and/or if that money has already been taxed in the foreign country.
Rather, the default position is that if you are required to file a U.S. tax return and you meet the minimum threshold requirements for filing a U.S. tax return, then you have to include all of your foreign income. If you already paid foreign tax on the income, you may qualify for a Foreign Tax Credit. In addition, if the income is earned income – as opposed to passive income – and you meet either the Bona-Fide Resident Test or Physical-Presence Test, then you may qualify for an exclusion of that income; nevertheless, the money must be included on your tax return.
What if You Never Report the Money?
If you are in the unfortunate position of having foreign money or specified foreign assets that should have been reported to the U.S. government, but which you have not reported — then you are in a bit of a predicament, which you will need to resolve before it is too late.
As we have indicated numerous times on our website, there are very unscrupulous CPAs, Attorneys, Accountants, and Tax Representatives who would like nothing more than to get you to part with all of your money by scaring you into believing you are automatically going to be arrested, jailed, or deported because you have unreported money. While that is most likely not the case (depending on the facts and circumstances of your specific situation), you may be subject to extremely high fines and penalties.
Moreover, if you knowingly or willfully hid your foreign accounts, foreign money, and offshore assets overseas, then you may become subject to even higher fines and penalties…as well as a criminal investigation by the special agents of the IRS and/or DOJ (Department of Justice).
Domestic Voluntary Disclosure
For many years, the IRS has had a domestic voluntary disclosure in place. The program is designed for anyone who is out of tax compliance for failing to report U.S. income.
What many people do not realize, is that their failure to file/pay U.S. tax on income earned in the United States may lead to significant fines, penalties and worse depending on the nature and extent of the non-compliance?
*Please keep in mind the program is designed for money that was earned legally but not reported; if the money was earned illegally — you do not qualify for the program.
When is Criminal Prosecution Recommended?
If the IRS catches you committing a tax crime, chances are they will investigate. As recent history has shown, Movie Stars, Musicians, Moguls and the like are all fair game when it comes to IRS Prosecutions. While there are no hard and fast rules regarding investigating tax crimes, the general consensus is that after two years of either non-filed tax returns, under-reporting income, embellishing deductions/expenses or any number of other related tax misgivings, you are begin to tread in criminal territory.
Moreover, situations that will greatly heighten your chances of getting caught, include:
- A scorned spouse or lover;
- Angry or vindictive Business Partner;
- Third-Party who just doesn’t like you (you would be amazed…);
- Someone who overheard something about what you did and wants to “blow the whistle”
- Someone who is already in trouble and uses information he or she has against you to leverage a better deal
How does Domestic Disclosure Help
As provided by the IRS: “It is currently the practice of the IRS that a voluntary disclosure will be considered along with all other factors in the investigation in determining whether criminal prosecution will be recommended. This voluntary disclosure practice creates no substantive or procedural rights for taxpayers as it is simply a matter of internal IRS practice, provided solely for guidance to IRS personnel. Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution.”
What does this Mean?
Presumably, if you make a full disclosure and pay all the necessary taxes, fines, penalties and interest associated with the disclosure — you should be able to avoid criminal prosecution. Of course, there are no guarantees, but the IRS does have somewhat limited resources; in other words, the IRS simply does not have the time or money to enforce tax crimes against each and every person who may have made a mistake – or worse – in prior tax years.
As further provided by the IRS:
– Voluntary disclosure will not automatically guarantee immunity from prosecution; however, a voluntary disclosure may result in prosecution not being recommended. This practice does not apply to taxpayers with illegal source income.
– A voluntary disclosure occurs when the communication is truthful, timely, complete, and when:
– A taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his/her correct tax liability.
– The taxpayer makes good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable.
How to Make a Domestic Voluntary disclosure?
Unlike the offshore disclosure programs, domestic voluntary disclosure program is a bit different. With offshore disclosure, there very specific rules and regulations involving the actual disclosure those rules and procedures are not met, then the disclosure will be rejected.
With the domestic voluntary disclosure program there is no one particular way to make a disclosure. Why? Presumably because there are so many different rationales and alternatives for somebody not reporting US-based income that a simple set of procedures would simply not suffice.
To that end, the Internal Revenue Service has provided guidance in terms of what would need to be done in order to facilitate an acceptable submission, as follows:
– A letter from an attorney which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full and which meets the timeliness standard set forth above. This is a voluntary disclosure because all of the elements set forth in (3) above, have been met.
– A disclosure made by a taxpayer of omitted income facilitated through a barter exchange after the IRS has announced that it has begun a civil compliance project targeting barter exchanges but before it has commenced an examination or investigation of the taxpayer or notified the taxpayer of its intention to do so. In addition, the taxpayer files complete and accurate amended returns and makes arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable. This is a voluntary disclosure because the civil compliance project involving barter exchanges does not yet directly relate to the specific liability of the taxpayer and because all of the elements set forth in (3), above have been met.
– A disclosure made by a taxpayer of omitted income facilitated through a widely promoted scheme that is the subject of an IRS civil compliance project. Although the IRS already obtained information which might lead to an examination of the taxpayer, it not yet commenced any such examination or investigation or notified the taxpayer of its intent to do so. In addition, the taxpayer files complete and accurate returns and makes arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable. This is a voluntary disclosure because the civil compliance project involving the scheme does not yet directly relate to the specific liability of the taxpayer and because all of the elements set forth in (3), above have been met.
– A disclosure made by an individual who has not filed tax returns after the individual has received a notice stating that the IRS has no record of receiving a return for a particular year and inquiring into whether the taxpayer filed a return for that year. The individual files complete and accurate returns and makes arrangements with the IRS to pay, in full, the tax, interest, and any penalties determined by the IRS to be applicable. This is a voluntary disclosure because the IRS has not yet commenced an examination or investigation of the taxpayer or notified the taxpayer of its intent to do so and because all of the elements set forth in (3), above have been met.