Decrypting Cryptocurrencies

What are cryptocurrencies? The news is teeming with excitement about cryptocurrencies, whether it be Bitcoin, Ethereum or one of the many other types of cryptocurrency. With the increasing popularity of this unregulated currency, it has not only garnered attention from the public but also the government, and thus the IRS. Even though cryptocurrencies are unregulated, it does not mean that they are unreported or nontaxable.

Blockchain & Bitcoin – What Does It All Mean?
There are many terms used when discussing cryptocurrencies and what they are. First, let’s take a look at blockchain technology. According to TechTarget, “blockchain technology” is defined as:

A type of distributed ledger for maintaining a permanent and tamper-proof record of transactional data. A blockchain functions as a decentralized database that is managed by computers belonging to a peer-to-peer network. Each of the computers in the distributed network maintains a copy of the ledger to prevent a single point of failure. All copies are updated and validated simultaneously.

Bitcoin, one of the most popular cryptocurrencies right now, is a digital currency system that was created using blockchain technology to allow for peer-to-peer encrypted transactions between two users. In fact, according to https://www.reliablecoin.com, Bitcoin has surpassed all other cryptocurrencies and taken the lion share of the crypto market.

The transactions are verified and recorded in a distributed ledger (the blockchain), which is available to all users of the system. This process can be used to transfer funds internationally through a much simpler process than Western Union, for example. A bitcoin transaction also can be performed remotely rather than going to a bank.

Bitcoin is one cryptocurrency in over 1,300 different cryptocurrencies available today. Others include Litecoin, Ethereum, Ripple and Tether, each operating and valued in different ways.

The most popular method to purchase Bitcoin is to use a secure online platform, like Coinbase, for buying, selling, transferring and storing digital currency called a “wallet.” There are other platforms available, but Coinbase is currently the most widely used.

Bitcoin has gained a lot of traction, and value, because of its popularity but also because of its applications. There are Bitcoin ATMs right here in Santa Barbara called “CardTronics” that will exchange Bitcoin to US Dollars immediately. More and more vendors are willing to accept Bitcoin for goods and services rendered, including gas stations, laundry mats and online merchants. The applications for using Bitcoin are growing every day. It is important to note that even if you don’t fully cash out of your chosen cryptocurrency, anytime you use it to pay for goods or services, you could be creating a taxable event.

Buyer Beware – Not a Regulated Currency
It is important to remember that while Bitcoin and other cryptocurrencies may function like cash, they are not a fiat currency. This means that it is not recognized nor regulated by any governmental agency. Once Bitcoin is transferred from one wallet to another, the transaction is complete. There are no “chargebacks” and very little traceability.

Until recently, there was no third party reporting to any governmental agency (like the IRS). This made cryptocurrencies attractive to individuals seeking privacy for various reasons. For example, hackers ransoming business information or those engaging in other illicit activities may find cryptocurrencies a beneficial form of currency. Some companies in the United Kingdom have been stockpiling Bitcoin in order to pay such a ransom in the event of a ransomware attack. This tactic has likely contributed to the increased prices and hype surrounding Bitcoin.

Cryptocurrencies could be popular for other reasons too. The days of a hidden Swiss Bank account are over, and there are few “off-shore” locations remaining to hide or stockpile assets. Cryptocurrencies are not just “off-shore,” they are “off-planet” in a sense. This entices consumers who want to maintain privacy. Currently, these funds cannot be seized by bankruptcy, probate, divorce court or creditors. And it is not clear how long this “privacy” will last.

With the lack of established governance or jurisdiction, there is no forum to address fraud or theft. While Bitcoin itself has never been hacked, a Coinbase wallet could be hacked, and all of its cryptocurrency transferred, verified and stolen. Cryptocurrencies are susceptible to identity fraud without the remedy available to reverse a transaction. If someone steals a credit card, the bank will reverse those fraudulent charges. No one, including a government or central bank, can stop a digital currency transaction from happening, which means that the traditional fraud protections are unavailable.

A Different Kind of Investment
Cryptocurrencies are not just a means of exchange; they are also attracting investors looking for alternative investments. People are buying and selling cryptocurrencies like securities. In January of 2017, one Bitcoin was worth about $1,000. It has since increased up to twenty times that amount. Bitcoin is extremely volatile and has seen spikes as high as $20,000 per Bitcoin and has dropped to $14,900 per Bitcoin in the same week.

Tax Planning Considerations
In 2014, the IRS issued Notice 2014-21, which detailed how cryptocurrencies should be reported and characterized on US tax returns. For US tax purposes, virtual currencies shall be treated as property. Each time an exchange is made, a taxable event occurs. The characterization of the transaction depends on how the virtual currency is treated in the hands of the taxpayer. For instance, if an employer pays employees in Bitcoin, then the employee will pay ordinary income tax on the fair market value (FMV) of the Bitcoin on the date of payment.

For example: BPW pays John Smith $1,000 in Bitcoin for his employment at BPW in January of 2017. John leaves the money in his Coinbase account that is secured with two-factor authentication security. Then, in March 2018, John sells his Bitcoin with a FMV of $20,000. On his 2017 tax return, he will report $1,000 of ordinary income; and on his 2018 tax return, he will report $19,000 of long term capital gains. The taxable event for the initial $1,000 is when the employer paid the employee, John, the wages in 2017. The second taxable event is when the Bitcoin was exchanged into either US dollars or another cryptocurrency in 2018.

On the other hand, what if John wants to exchange his Bitcoin for a less volatile cryptocurrency (like Tether) and keep his cryptocurrency in the cloud? Does this create a taxable event? While it is unclear how the IRS will rule on the use of Section 1031 (like-kind exchanges) to exchange between cryptocurrencies, one thing is clear: the use of Section 1031 to defer gains has strict filing requirements. John must file all the necessary paperwork with his tax return to avoid noncompliance and tax evasion.

With the recent Tax Cuts and Jobs Act, the ability to use Section 1031 exchanges for anything beyond real estate was eliminated, so for transactions in 2018 and beyond, they most likely cannot be treated as a Section 1031 exchange.

Until recently, there was no third party reporting to the IRS. Buying and selling Bitcoin was like the gold rush and the days of the Wild West. In November 2016, however, the IRS issued a John Doe summons on Coinbase that was settled a year later on November 29, 2017. Coinbase will be releasing information to the IRS on all “wallets” with a value of over $20,000 between the years 2013 – 2015. Once they have gone through those transactions, requests for 2016 and 2017 are likely next…

Moving Forward
While the IRS is still developing its approach to cryptocurrencies, we know that more regulations are coming, and it is important to anticipate the day when they will be implemented. Keep records of your cryptocurrency transactions, not only to determine your cost basis and whether there was a capital gain or loss, but to serve as back-up that you endeavored to document and report your transactions, even when the requirements were uncertain.

If you are currently exchanging or looking to get more involved with cryptocurrencies, please contact your advisor at (805) 963-7811 to ensure IRS compliance and state tax reporting, as well as any potential foreign reporting requirements.