Current estimates indicate about 14% of American adults own virtual currency, also known as cryptocurrency and bitcoin. Virtual currency is a unit transaction that is recorded on a digital ledger through what is called blockchain technology and is accessed digitally. Cryptocurrency a decentralized network of millions of computers all over the world.
The concept originated at Stanford University in the 1970s, but not until 2008 were blockchain networks able to provide the roadmap for virtual currency to explode. The attraction for the early participants was that it could be owned anonymously and transferred or sold anonymously. It could cross geographical borders without any trace, making it free of government regulation. The early uses were mainly on the dark web and used by organized crime to launder money. This is why we hear about companies being blackmailed with ransomware and criminals demanding payment in bitcoin or cryptocurrency.
Now that virtual currency has become a part of our economic culture many economists are very concerned. Few people buying cryptocurrency understand the true risks involved. Since it has gone up dramatically in value, purchasers assume that it will continue to do so. However, cryptocurrencies are not backed by any governments or tangible asset; they pay no dividends; and they are extremely volatile. Virtual currency has lost more than a third of its value in a period of hours. In March of 2020 it dropped 50%.
Virtual currency has now reached a point where it has attracted hundreds of billions of dollars worldwide. Economists who adhere to the Economic Law of Means of Reversion (the law that states every asset will revert to its true value in any marketplace) believe that since there is no underlying tangible foundation for cryptocurrency, it must return to its real value of $0. The question is always, when? This is not to say that you cannot make money using cryptocurrency, but it should be viewed as a gamble or a game and not a safe place to invest for long-term investments.
As with any other appreciating assets the IRS has taken notice. IRS scrutiny of virtual currency has increased along with their issuance of guidance on how to report income produced by virtual currency.
Here’s what you need to know to stay out of trouble with the IRS at tax time if you are buying cryptocurrencies.
The IRS requires virtual currency to be treated as property, like stocks or real estate, unless you receive virtual currency as a payment for services for tax purposes. One upside is if you hold virtual currency for more than a year, it will be taxed at a lower rate because it is considered a long-term gain when you dispose of it. The downside is that you must report every disposition (when you sell or otherwise get rid of virtual currency). And you must match the value of the disposed unit of virtual currency with the original value of that same unit of virtual currency.
You are not required to report to the IRS when you buy virtual currency or receive it as a gift. You must report a gain or loss to the IRS every time one of the following transactions takes place:
- Sell virtual currency for dollars.
- Exchange one type of virtual currency for another.
- Use virtual currency to pay for goods or services.
- Receive virtual currency for services.
- Mine virtual currency.
At tax time, your tax advisor will need information on every unit of virtual currency that was disposed of during the tax year. And they will need the original value of that same unit of virtual currency.
Unless you are prepared to keep a minutely detailed spreadsheet that includes the long numbers associated with virtual currency, you will want to use an app to track your virtual currency that provides an IRS Form 8949 at the end of the year. The exchange you are using may have a recommendation for an app that works well.
The IRS’ interest and audit rate will continue to increase as virtual currency becomes more popular. Check with your tax advisor on how you can be prepared to report virtual currency accurately.