United States: Three Key Federal Income Tax Issues Raised By Cryptocurrencies

BACKGROUND

Cryptocurrencies – the original, and most famous of which, Bitcoin, was "designed" in 2009 by Satoshi Nakamoto (a pseudonym) – give rise to a number of tax issues, three of which we discuss in this article: (1) the effect of using Bitcoin to buy a good or service, (2) the treatment of mining Bitcoins, and (3) what happens from a tax perspective when there is a so-called hard fork of a cryptocurrency into two cryptocurrencies.

In simple terms, a cryptocurrency (also referred to as "virtual currency" in IRS publications) is "a digital asset designed to work as a medium of exchange that uses cryptography to secure its transactions, to control the creation of additional units, and to verify the transfer of assets" (emphasis added).1 Although we focus on Bitcoin in this article, there are many cryptocurrencies, such as Ether, Ether Classic, Litecoin and Bitcoin Cash.

Valuation and Trustworthiness of a "Currency"

On April 10, 2018, a single Bitcoin was worth over $6,800, but the value has been quite volatile, and

 some think that this is a speculative bubble and that Bitcoins will ultimately be worth $0. How does Bitcoin have value? For any currency, or indeed any widely circulated asset, to have value, whether it be a United States dollar or a Bitcoin, the population at large or a significant percentage of the population at large must accept that it will be usable to buy goods and services. That, in turn, generally requires that the population trust that the currency "tokens" will be limited in number (either a fixed number or a reasonable mechanism for increasing them) and that they are not easily counterfeited. Trust is of course a necessary but not sufficient condition.

For dollars – and the bank accounts that hold them – trust is based on the issuer of the currency (the United States Government), and, in the case of bank accounts, on the bank holding the currency. In the case of Bitcoin, that trust is based on three features.

  • First, the software that creates the Bitcoins is open-source and available to all.
  • Second, every transaction in Bitcoin has an entry added to a massive encrypted ledger (the so-called blockchain2), so a merchant (or
  • other Bitcoin transferee) can see that a transfer of a Bitcoin to his wallet3 was made.
  • Third, and most importantly, the method by which Bitcoins are created (referred to as "mining" a Bitcoin) and transferred is designed so that duplicate or fake transactions are extremely hard to accomplish.

The Method Used for Modifying the Blockchain

Though a full description of the method by which Bitcoins are created and transferred is technically sophisticated and beyond the scope of this article, the shorthand version is as follows.

  • Miners earn Bitcoins by adding blocks to the blockchain, where each block represents a group of transactions.
  • A miner adds a block to the blockchain by solving (via brute-force trial and error) a computationally intensive mathematical problem that relates to the then-existing blockchain, as well as the transactions associated with the block to be added.
  • The first miner to solve the problem and add the block to the blockchain receives a reward in the form of not only new Bitcoins, but also transaction fees associated with the transactions in the block. By offering transaction fees, buyers and sellers provide incentives to miners to prioritize adding the buyers' and sellers' transactions to the blockchain.
  • Once a miner solves the problem, other miners and every participant's software can quickly verify that the solution is correct, and the transactions in the block are irrevocably added to the blockchain.
  • Ultimately, there is a fixed number of Bitcoins that can be created, so eventually Bitcoin transactions will be done based on the transaction fees offered by participants to solve the mathematical problems. It should be noted that the mathematical problems get increasingly more complicated (for technical reasons relating to the increasing computing power used to mine the Bitcoins) and require increasing amounts of electrical power; the basic idea is that someone wanting to put in a fake transaction, or two inconsistent transactions, would have to have more calculating power than ALL THE OTHER MINERS on the network combined who are solving the mathematical puzzle with a proper block.

TREATMENT OF USING BITCOIN TO BUY A GOOD OR SERVICE

Bitcoin Treated as Property

The IRS stated in Notice 2014-21 that virtual currencies such as Bitcoin are not treated as currencies, but instead are treated like other property. If property is used to buy a service or good, any gain or loss on the property is recognized, generally as capital gain or loss. The IRS determined that the same treatment applies to virtual currencies. Accordingly, the use of a Bitcoin to buy a good or service triggers the recognition of any gain or loss on the transfer of the Bitcoin (determined by comparing the value of the Bitcoin at the time of transfer to its tax basis). The gain recognized is capital gain if the Bitcoin is a capital asset in the hands of the taxpayer (not, e.g., a dealer in Bitcoin). Consequently, Bitcoin investors may wish to hold Bitcoin for more than a year to ensure long-term capital gain treatment. Investors should also note that, as Bitcoins are personal property, a like-kind exchange cannot presently be done with Bitcoins or other cryptocurrency, as the recently enacted tax lawlimits like-kind exchanges to real property only.4

Tax Basis of a Bitcoin

The taxbasis of a Bitcoinacquired by purchaseorexchange generally is the fair marketvalue at thetime itwas acquired. For example,buying aBitcoinfor$7,000 would result in a tax basis of$7,000. Sellingit later for$8,000 would result intaxable gain of $1,000. The tax basis of a Bitcoinobtained throughminingdependsontheincomerealized on mining andis discussed inTreatmentof BitcoinsEarned throughMining,below.

Methodologies for Determining Basis of a Sold Bitcoin

Presumably, basis for determining gain or lossfrom a specific wallet could be done under a FIFO (first in first out), LIFO (last in first out), orspecific-share identification method (commonlyused instocktrading).Asnoguidancehasbeenissued, taxpayers may be able to choosewhichmethod they wish to use, as long as they continueto report it consistently.5As a practical matter,however, itis difficult if not impossible to identify a specific Bitcoin to be sold.

IRS Remaining Vigilant

TheIRShas not forgotten the issue ofBitcointaxability in the years since 2014: on March 23,2018, the IRS issued a reminder to taxpayers thatincomefromvirtual currency transactions isreportable on their income tax returns, and thatthe IRS willbemonitoring this.

4Section 13303 of the recent tax bill (P.L. 115-97)amended Section 1031(a) of the InternalRevenue Code of1986, asamended, to replacethe term "property"with the term "realproperty."

5LIFO maybe more favorable formanycryptocurrency traders, as Bitcoins purchased earlier in time were likelypurchased at a lowervalue than theirpresent value. However, FIFOhas the benefit ofmaking it easier to satisfy thelong-term capital gainholding period.

TREATMENT OF BITCOINSEARNED THROUGH MINING

Timing ofIncome Recognition

In Notice2014-21, the IRSalso determined that Bitcoins earned through mining were gross incomeat the time earned. This is a somewhat morequestionable conclusionthan the treatment of Bitcoins as property that is not a currency. To theextent that theBitcoinsmined have not been used,itseems plausiblethat theBitcoins should betreated like a valuable metal such as gold,whichisnot income at the time mined,but onlywhen used.MinedBitcoins arealso like an asset that someonegenerates bymanufacturing: the value of the assetis not included in incomeuntil the asset is sold.On the other hand, consistent with the IRS's position, when a party performs a service andreceives payment for the service in the form ofproperty, the value of the property received isincome at that time. By analogy,it could beargued that the miner isbeingpaidby the networkfor theworkitisdoinginverifyingtransactions.It's an openquestion as to which analogy is moreappropriate, although the IRS has expressed itsview.

Tax Basis ofMined Bitcoins

Whether income isrealized on the mining of aBitcoin also has a bearing on the Bitcoin's basis. Ifno income were realized on the mining of aBitcoin, theBitcoinwould presumably have no taxbasis other than capitalized costs used inproduction of the Bitcoin,6such as theappropriateportion of thecost of hardware used in mining(which issubject to potential depreciation oramortization).If,however,income isrecognizedat the time ofmining (based on fair market value),the miner would take this full fair market value astax basisin the Bitcoin.

Deductions

Regardless of whether income is realized on the miningofaBitcoin,certaincostsassociated with mining Bitcoins may be deductible, such as the cost of the electricity used in mining the Bitcoins – although there is no specific IRS guidance on this point. Taxpayers may wish to consider whether their mining is an investment activity (in which case deductions may not be available, pursuant to the recently enacted tax law 7) or whether it rises to the level of a trade or business. Additionally, miners should consider whether certain costs may or must be capitalized (rather than deducted) under the applicable Treasury Regulations.

HARD FORK

Background

A hard fork with a cryptocurrency occurs when there is an update to the currency software or the blockchain and some miners do not agree to the changes and continue using the old software or the old blockchain. This has already occurred a few times. One example occurred with Ether, when a change was made to undo a program run on Ethereum that had been hacked, and the hacked version of the blockchain was continued under the name Ether Classic. Another example is Bitcoin Cash, which incorporates a software change to Bitcoin. Bitcoin Cash was not accepted by some miners, who have continued using the old software – Bitcoin. Going forward, transactions on the new software (Bitcoin Cash) are not recognized by the old software (Bitcoin) and vice versa. It is generally presumed that one of the two will eventually decline in usage as the other becomes more widely accepted, although that is speculation at this point in time.

Effect for Holders of the Cryptocurrency

With a hard fork, holders of the old coin get an equivalent amount of the new coin in addition to their old coin. This does not create "free money," however – it is analogous to a stock split or stock dividend: the value of a cryptocurrency immediately after a hard fork would generally be expected to be split between the old version and the new version.

Guidance on Tax Treatment of a Hard Fork

The IRS has not indicated how it believes a hard fork should be treated. The American Bar Association's tax committee recently issued a report8 suggesting that a good analogy could be made to transactions that give rise to a recognized gain or loss, but also that a good analogy could be made to transactions that do not give rise to a recognized gain or loss. Until the IRS determines the appropriate treatment, the ABA report suggested a safe harbor, whereby a hard fork would result in a recognition transaction, but the new coin would be considered to have a value and basis of $0. The report recognized that this would mean any gain (after holding the new coin for more than one year) would be long term capital gain. Of course, it may be debated which coin should be treated as the "new" coin.

Footnotes

 1 Wikipedia, Cryptocurrency, available at https://en.wikipedia.org/wiki/Cryptocurrency  

2 regardless of whether cryptocurrencies are ultimately successful as currencies the blockchain concept, which can help ensure the security of transfers or perform other functions, is becoming widely used and has independent value. For example, the Ethereum blockchain is used to perform software functions on a distributed basis.

3 A wallet is software that a holder of Bitcoin uses to hold his or her Bitcoins and to transfer or receive Bitcoins from other holders.

4 Section 13303 of the recent tax bill (P.L. 115-97) amended Section 1031(a) of the Internal Revenue Code of 1986, as amended, to replace the term "property" with the term "real property."

5 LIFO may be more favorable for many cryptocurrency traders, as Bitcoins purchased earlier in time were likely purchased at a lower value than their present value. However, FIFO has the benefit of making it easier to satisfy the long-term capital gain holding period.

6 See generally Treas. Reg. § 1.263(a)-4.

7 Section 11045 of the recent tax bill added a new Section 67(g) to the Internal Revenue Code of 1986, as amended, which provides that miscellaneous itemized deductions are suspended through 2025.

8 Comments to the IRS commissioner dated March 19, 2018.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions