The Taxation of Cryptocurrencies.

• Author: Erdmann, Charlotte A.

Cryptocurrency and block-chain technology have grown in popularity and ubiquity in the past few years. Just within the last year alone, the most well-known and popular type of cryptocurrency, Bitcoin, has grown in value from $6,805.38 to $57,517.80. (1) The Internal Revenue Service defines cryptocurrency as a "type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger such as blockchain." (2) Virtual currency is a digital asset that is used as a medium of exchange and typically stored electronically in digital wallets. Since the technology, uses, and types of blockchain technology and virtual currency are developing so rapidly and growing in number, regulatory agencies are having a hard time keeping up with the developments and legal implications of these developments. This article focuses on how virtual currency is taxed and the wider implications of virtual currency in federal tax law. (3) This article does not explore the banking, securities, or other legal implications of cryptocurrency.

The Technology of Cryptocurrency

Cryptocurrency relies on block-chain technology. A blockchain is a data management system that stores significant amounts of data. Unlike a typical database that stores information in tables, a blockchain collects and stores information in groups, known as blocks. Blocks have certain storage capacities and when filled are chained onto previous blocks forming a chain of data called a "blockchain." The blockchain structure provides an irreversible timeline of data when implemented in a decentralized nature. When a block is filled, it is set in stone, and each block in the chain has a precise timestamp that serves as a digital signature to verify each transaction. This system of data collection is particularly useful in the banking and financial services industry since blockchain can track payment rails, which is how money moves among people, businesses, and accounts. (4)

Cryptocurrency has value based on several different factors, similar to securities. Like securities, some factors that give the virtual currency value stem from the image and efficiency of the companies behind them. Additionally, user demand, scarcity, and the coin's utility all play a role in making a virtual currency valuable.

How is Cryptocurrency Taxed?

Virtual currencies are treated as property and not as currency for federal tax purposes in the United States. (5) This is in stark contrast to how most countries treat virtual currency, which is as standard fiat currency. (6) Under IRS Notice 201421, taxpayers must recognize gain or loss on the exchange of virtual currency for cash or for other property. (7) Gain or loss is, thus, recognized and taxable, every time that virtual currency is sold or used to purchase goods or services, including other types of virtual currency. (8) To determine the amount of capital gain or loss, one needs to know the basis of the virtual currency and the fair market value of the virtual currency when sold or otherwise transferred. (9) The nature of gain or loss, and, thus, the rate at which it is taxed, is also determined by how long the virtual currency is held before its disposition. (10) Short-term capital gain is the gain occurring from the sale or exchange of virtual currency when it is held less than one year. (11) Long-term capital gain is the gain that occurs from the sale or exchange of virtual currency when it is held for more than one year. (12) Under the current tax rate structure, long-term capital gains are taxed at a lower, and, thus, more favorable, tax rate. (13)

The fair market value of virtual currency can sometimes be difficult to determine and depends on how the virtual currency is acquired. If virtual currency is acquired through a cryptocurrency trading platform or exchange, the value of the cryptocurrency is the amount that is recorded by the cryptocurrency exchange for that transaction. (14) If the transaction happens "off-chain," which means the transaction is not recorded on the distributed ledger, then the fair market value is the amount the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it were an "on-chain" transaction. (15) If the virtual currency is acquired in a peer-to-peer transaction or some other transaction that does not involve an exchange, the fair market value is determined as of the date and time the transaction is recorded on the distributed ledger or would have been recorded on the ledge if it is an "off-chain" transaction. (16)

Basis

The basis in the virtual currency is what is paid for it plus any transaction fees incurred in the purchase. (17) Because virtual currency is property and not currency, one must always keep track of basis issues, even when dealing with microtransactions. For example, let us say more than one year ago, Frank paid $15,000 to purchase 1 bitcoin. It cost $14,998 for the bitcoin and $2 for the transaction fee. He bought the bitcoin for investment purposes. His basis in the 1 bitcoin is $15,000. Let us assume that the 1 bitcoin currently trades for $20,000. Using the bitcoin, Frank purchases a slice of pizza for lunch worth $5. He also pays Joe, an independent contractor, $2,000 to build him a fancy new website. For the pizza purchase, all of the following occurs as part of the transaction: Frank uses 0.00025 of the bitcoin to make the pizza purchase leaving him with 0.99975 bitcoin. The amount of bitcoin used to purchase the pizza has $3.75 of allocated basis (0.00025 x $15,000). Since the pizza was worth $5, Frank recognized $1.25 of long-term capital gain that is reportable on his return and is taxable ($5-$3.75). After the pizza transaction, Frank has 0.99975 bitcoin remaining with a basis of $14,996.25. Regarding the website build: Frank uses 0.1 bitcoin ($2,000/$20,000) that has an allocated basis of $1,500 ($14,996.25/0.99975). He recognizes $500 of long-term capital gain ($2,000-$1,500). If he purchases the website in the course of a trade or business, he receives a $2,000 deduction. After the website build and the pizza lunch, Frank has 0.89975 bitcoin left with a basis of $13,495.25. Joe, the independent contractor, has 0.1 bitcoin with a basis of $2,000 but also realizes $2,000 of income subject to self-employment tax. If Joe later sells that 0.1 bitcoin, he will need to recognize and report short-term or long-term capital gain or loss depending on how long the bit-coin is held and the fair market value of that bitcoin at the time of the sale.

The IRS Allows Taxpayers to Specifically Identify Units

The simple example of Frank and Joe illustrates how quickly and how complicated reporting virtual currency transactions can become, especially when there are different types of virtual currencies, all with different values, and those "coins" may be acquired at different times, with different holding periods. How is one to calculate the appropriate gain or loss unless one can identify which coin was sold and its basis? Prior to the IRS releasing its FAQs on virtual currency, it was thought that since virtual currency is usually held for investment purposes, like stock, it should be subject to the same basis and accounting rules as stock and as such, unless other specific exceptions are made, the "first in, first out" (FIFO) method should be used in identifying which "coin" is sold or transferred, which determines the gain or loss of the transaction. (18) One of the exceptions to FIFO as it relates to stock is if there can be "adequate identification." (19) The obvious issue with adequate identification is whether that could ever be applied to virtual currency. With bitcoin, for example, there is no actual "coin"; it is just an entry on a distributed ledger. Fortunately, the IRS did provide guidance in its FAQs that permit taxpayers to choose which units of virtual currency are sold if those units can be "specifically identified." (20) If the units of virtual currency are not specifically identified, then the first in, first out method is to be used. (21) A taxpayer can use specific identification by documenting the specific unit's unique digital identifier, such as a private key, public key, and address, or by records showing the transaction information for all units of a specific virtual currency held in a single account, wallet, or address. (22)

The information must show (1) the date and time each unit was acquired, (2) the basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit. (23)

The ability to use specific identification allows a taxpayer to cherry-pick the most advantageous tax treatment and it is further applicable universally across all wallets or virtual currency holdings and not limited to per-wallet application. (24)

Mining Virtual Currency

When people mine virtual currency, they are using computer resources to validate transactions and help maintain and cross-reference the transaction ledger. As part of their effort and use of resources, they earn virtual currency. Pursuant to IRS Notice 2014-21, the mined virtual currency has a fair market value, and is included as gross income, as of the date of receipt. (25) The fair market value of the cryptocurrency is determined as of the date and time the transaction is recorded on the...