Individual income tax returns are due on April the 17th this year and US citizens who wish to stay on the right side of the law will need to record their crypto cashflow to avoid getting on the IRS’s radar in a bad way. And they do have an excellent radar, especially given recent court decisions forcing Coinbase to hand over millions of user transaction records to tax investigators.
So what should you be asking (or telling) your tax advisor about cryptocurrencies before you file this year? We asked several legal and accounting experts for their take on the most important questions.
David W. Klasing
David W. Klasing practices as an attorney and a certified public accountant in California in the areas of taxation, estate planning and business law. A former auditor, David now provides businesses and individuals with comprehensive tax representation, planning & compliance services and criminal tax representation. He has more than 20 years of professional tax, accounting and business consulting experience.
What should I do if I have not been reporting my cryptocurrency activity for several years and/or my information has been provided to the department of justice income tax division under a John Doe Summons?
If you had a Coinbase account or otherwise mined, held, traded, or engaged in transactions involving cryptocurrencies during 2014, 2015, or 2016, it is essential to take steps to mitigate the potential consequences you face and you may need to file an FBAR. This may include amending past tax returns, filing missed returns, or making voluntary disclosures. The IRS has taken steps to identify taxpayers who are utilizing Bitcoin and cryptocurrency to commit tax evasion and it is highly likely that it will become increasingly aggressive in its enforcement activities. With regards to the impact of the Court granting the IRS request for a Coinbase John Doe summons, this means the IRS is likely to obtain all Coinbase account user data. Once the IRS has this data, it will likely identify taxpayers who have concealed income, or failed to pay capital gains or income taxes.
If you have sold Bitcoin, been paid for work performed in Bitcoin, paid employee wages in virtual currency, or engaged in an array of other transactions, it is prudent to seek the advice of a tax attorney. You should contact a tax lawyer because if you are concerned about potential criminal tax charges, only the attorney-client privilege is sufficient to protect the disclosures you may make when seeking legal guidance. If you make these same disclosures to an accountant or CPA, it is very likely that the IRS will subpoena the CPA and he or she will become the government’s number one witness against you.
What are the tax consequences of a hard fork?
The landmark case Commissioner v. Glenshaw Glass may be instructive in determining if the receipt of new crypto-currency as a result of a fork results in a taxable event.
Accession to Wealth
The first prong of the Glenshaw Glass test is whether the taxpayer had an accession to wealth. This depends on the circumstances of the fork. If the new digital currency has an ascertainable value at the time of the fork, the IRS has a solid argument that the fork resulted in the taxpayer having increased wealth due to the fork. On the other hand, if a fork results in a digital coin that has no value until the market determines whether it should increase in value, the IRS will have a difficult time proving that the fork was a taxable event that yielded an accession to wealth.
The second prong requires that the taxpayer clearly realize their ascension to wealth. Realization occurs when value of property is actually received by the taxpayer. The inability to take possession or control their new wealth delays the realization event until they can, if they ever do. Cryptocurrency owners who hold their ownership keys directly have full control of their new wealth (if any) immediately after the fork occurs. Crypto-currency owners with digital wallets through Coinbase or a similar exchange do not realize their new wealth (if any) until they receive the right to control the new cryptocurrency once their exchange supports it. If an exchange never supports a newly created digital currency, a taxpayer has a strong argument that a realization event never occurred.
The final prong of the test from Glenshaw Glass requires a taxpayer to have complete dominion and control of the new money or property they have acquired. Typically, this test is easily met with regard to cryptocurrency owners who hold their keys directly as they are able to dispose of their interests in the new digital currency immediately. Those who use digital currency exchanges may not be able to exercise dominion and control of the new currency created by the hard fork if their exchange of choice does not support the new crypto-currency.
Finally, in terms of a hard fork being characterized as a capital gain or income, the Internal Revenue Code defines capital gain as gain from the sale or exchange of a capital asset. Although cryptocurrency may be a capital asset in the hands of most taxpayers, a hard fork does not appear to be a sale or an exchange as owners of a cryptocurrency receive a different type of cryptocurrency only by virtue of owning their original crypto-currency. For that reason, it appears logical that the conferring of the ownership of a different type of cryptocurrency would not be a sale or exchange and thus, would be taxed as income.
Do I have to do foreign bank account reporting “FBAR” on offshore Cryptocurrency exchanges or foreign wallets I have utilized on FinCen form 114?
In addition to being required to report capital gains, taxpayers are also required to report foreign accounts that exceed, at any time during the pertinent tax year, certain thresholds: $10,000 in aggregate for FBAR (Report of Foreign Bank and Financial Accounts) under the Bank Secrecy Act (BSA), and $50,000 in aggregate for Form 8938 (Statement of Specified Foreign Financial Assets) under the Foreign Account Tax Compliance Act (FATCA). In the past, this traditionally meant bank or other financial accounts; but it can also extend to foreign Bitcoin wallets and exchanges. Thus, taxpayers who use Bitcoin may be required not only to report capital gains on Form 8949, but to:
File Form 8938 (Statement of Specified Foreign Financial Assets)
File an FBAR (FinCEN Form 114, also called FinCEN Report 114, previously Form TD F 90-22.1)
Toward that end, there are at least three crucial points which taxpayers should understand about foreign Bitcoin reporting requirements:
It is not in your best interests to close the account. Do not make the mistake of panicking and closing your foreign Bitcoin account. This will not erase digital records of previous transactions, which the IRS can obtain by using subpoenas (as it already has against Coinbase), then utilizing sophisticated computer software to scrutinize user files. What it will do is suggest that you were trying to cover up wrongdoing, which indicates “willful” (deliberate) nondisclosure, which in turn exposes you to greater penalties – including the risk of criminal prosecution. If you have concerns about a foreign Bitcoin wallet or account, the appropriate course of action is to immediately contact a skilled tax attorney for guidance.
You may be in jeopardy from whistleblowers. Certain federal laws, such as 26 U.S. Code § 7623, authorize the government to compensate whistleblowers for “detecting underpayments of tax,” or, in some cases, “detecting and bringing to trial and punishment persons guilty of violating,” or attempting to violate, the Internal Revenue Code (IRC). Depending on the situation, you might be at risk of exposure by whistleblowers seeking to capitalize on such laws. The takeaway is that, even if you believe you are safe from IRS detection, it is “better to be safe than sorry,” which segues into the next point.
The sooner you disclose, the better – but make sure you have legal guidance. The IRS offers programs, such as the Offshore Voluntary Disclosure Program (OVDP), which allow taxpayers to receive lighter financial penalties in exchange for voluntarily reporting past noncompliance with offshore reporting requirements. Depending on your circumstances, participating in the OVDP may be beneficial to you. However, due to the immense complexity (and high legal stakes) involved in these matters, you should review your options with an international tax law attorney before contacting the IRS.
What do I do if I am unable to obtain all of the information on my cryptocurrency activity because a coin brokerage I utilized no longer exists or for some other reason beyond my control?
Utilize estimates that attempt to be fair to the taxpayer and the government and disclose that estimates were utilized and why they were necessary. This increases audit risk slightly but is grounds for penalty abatement if the IRS has a different take on how your income should have been estimated.
Ines Zemelman has over 20 years experience in US International and Expatriate Taxation and is the founder and president of Taxes for Expats. She is an IRS-authorized EA specializing in tax issues faced by American citizens living abroad — such as foreign earned income and tax treaties.
How is virtual currency treated on my U.S. tax return?
The IRS treats virtual currency as property. As such, general tax principles applicable to property transactions apply to transactions using virtual currency. In English, this means capital gains, crypto sales are treated much like stock sales. Also note that 3.8% Net Investment Income tax (NIIT) may apply.
I purchased then sold crypto at a profit and purchased real property — do I have to report this on my tax return?
Yes — the sale of the crypto is reportable. For example, you purchased 50 bitcoins for $1000 on Jan 1 2017 — ie your basis was $50,000. On Apr 2, 2018 that bitcoin is now worth $350,000 (50 * $7000), and you purchase a home for that amount —paid with a transfer of bitcoin.Effectively, the tax treatment is the same as if you simply sold the bitcoin for $350,000. The taxable capital gain is $300,000; (350,000-50,000). The home purchase, however, would not be reportable (if/when you decide to sell the home, it would be reportable)
In the eyes of the IRS, Is bitcoin mining self-employment?
It depends. If the ‘mining’ is your main trade or business and you are not undertaking the activity as an employee for another person or entity (ie — a crypto fund), then this is self-employment. The net earnings from self-employment (ie — your revenue less your allowable deductions (costs)) resulting from those activities constitute self-employment income and are subject to self-employment tax (SECA).
If you work for a company that hires you to mine bitcoins, and receipt of bitcoins is not in your name, but for the company, then you are an employee and not subject to SECA tax. If ‘mining’ is your hobby and you engage in it for your own pleasure expecting to make money from crypto trading, then it is not a self-employment activity. You cannot deduct the cost of related expenses (i.e. hardware, increased electrical bill).
I’m paid in cryptocurrency — what are my reporting requirements? How do I calculate my income when the coins are so volatile?
If you receive virtual currency (i.e. Bitcoin) as payment for goods or services, the fair market value of the virtual currency must be added to your gross income.The fair market value must be determined on the date that the virtual currency was received (Brave New Coin has easily searchable historic US$ pairs available for most cryptocurrencies)
If I buy one type of coin, and sell it to buy another, how is this reported?
Each transaction must be reported. If you buy one coin and sell it to buy another, this is a taxable event (just like selling bitcoin to buy your new home). Keep accurate records — they will be very useful come tax time.There are many online services that help aggregate your trades into an easy to read format which will help your tax advisor get you sorted.
Jeff Vandrew Jr
Jeff Vandrew Jr is an Attorney, a Certified Public Accountant, and a CFP. He is academically published, with articles on estate planning and tax planning featuring in various legal outlets, including the New Jersey Law Journal. He is the founder of Vandrew LLC, a New Jersey estate planning firm that assists clients with cryptocurrency estate planning issues.
Do you handle FinCen Form 114 and Form 8938 (a/k/a the “FBAR”)?
Unfortunately, as with many cryptocurrency tax issues, it isn’t fully clear as to when these forms are required. FBAR reports are required of all “United States persons” who have an account with a foreign financial institution. This makes a few things clear. First, any cryptocurrency held in a paper wallet, hardware wallet, or other similar method by which you personally hold your private key would not be disclosable on an FBAR, as no foreign financial institution would be involved.
Second, any cryptocurrency held on a US-based exchange would not be disclosable on an FBAR. While GDAX and Gemini, for example, probably are “financial institutions” for FBAR purposes, because they’re based in the United States FBAR disclosure wouldn’t apply. The situation becomes murky for clients using non-US exchanges, such as Binance. Since cryptocurrency held in an exchange is held under the exchange’s keys, not your own, the exchange effectively has custody of its customers’ funds. While there are no FBAR regulations addressing cryptocurrency exchanges, their custodial function makes them seem a lot like “financial institutions”. This would make any cryptocurrency held in a non-US exchange disclosable on an FBAR.
You have nothing to lose by disclosing foreign cryptocurrency exchange accounts on an FBAR (and the related Form 8938), so it makes sense to take the safe route by disclosing. At any time, the Treasury Department could retroactively issue guidance clarifying that non-US exchanges are foreign financial institutions. The penalties for failure to disclose an account at a foreign financial institution on a timely FBAR form are some of the most severe in existence.
Should I disclose my forks?
While the IRS has not specifically addressed the tax treatment of cryptocurrency received in a fork, most practitioners believe that the value of the coins received is taxable ordinary income on the date of the fork. The amount of income would be the fair market value of the coins received on the fork date. This would be reported on Line 21 of Form 1040. This is particularly relevant in 2017, when Bitcoin forked multiple times. The taxable income claimed from any such fork becomes your tax basis if you later sell the forked currency.
Can I do an IRA or Self-Directed 401(k)?
If you’ve got a big tax bill coming, contributions to an IRA or 401(k) may blunt the effect. If you’re self-employed, your 401(k) would have had to have been created by 12/31/17 to take a deduction on your 2017 taxes. However, it’s not too late to still do a SEP-IRA for the self-employed, or Traditional IRA if you’re an employee. Consider setting up either of these as a self-directed IRA or self-directed 401(k). These self-directed options would allow you to trade cryptocurrency within your retirement account on a tax-free basis.
Can I deduct my mining equipment?
If you are engaged in mining cryptocurrency, so long as you are doing it on a continuous basis with the expectation of profit, it probably qualifies as a “trade or business”. If you qualify, this would allow you to take the generous Section 179 deduction, which allows you to write off the full cost of any specialized hardware you may have purchased.
Does the home office deduction apply to me?
As mentioned above, if you’re a miner, you may qualify as a “trade or business”. If you’re mining from home, you may then be eligible to take the home office deduction, which makes a portion of things that are usually nondeductible (utilities, rent, etc) partially deductible against your mining income.
Disclaimer: Information provided is for educational purposes only. Nothing herein constitutes legal advice.