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4 June 2020

Investing In Cryptocurrency: How To Avoid Unpleasant Tax Surprises

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As investing in Bitcoin and other cryptocurrencies becomes increasingly popular, investors need to understand the potential tax ramifications.
United States Technology

As investing in Bitcoin and other cryptocurrencies becomes increasingly popular, investors need to understand the potential tax ramifications. This year, the IRS has added a question on Schedule 1 of Form 1040 asking about any transfers of interest in virtual currencies. Unlike traditional currency, the IRS views cryptocurrency as property for federal income tax purposes. This means that many transactions involving cryptocurrency — such as purchases of goods or services — become taxable events where the purchase is also considered a sale. In addition, certain changes to the blockchain (the distributed digital "ledger" on which cryptocurrency transactions are typically recorded) can trigger taxable income. Here is what you need to know.

Capital gains and losses

Because cryptocurrency is property, investors recognize a capital gain or loss when they sell it in exchange for traditional currency. As with other capital assets, the amount of gain or loss is the difference between the adjusted basis in the cryptocurrency (usually, the amount paid to acquire it) and the amount for which it is sold. And, as with other capital assets, gain or loss may be short term or long term, depending on whether an investor held the cryptocurrency for more than one year. If cryptocurrency is sold at a loss, there may be limitations on the deductibility of the capital losses.

Cryptocurrency owners often are surprised to discover that using cryptocurrency to pay for goods or services can also trigger a capital gain or loss. Let's say you purchased ten units of cryptocurrency ten years ago for $1,000 each, or a total of $10,000. This year, when the cryptocurrency's price has climbed to $5,000 per unit, you use it to purchase a $50,000 car. Assuming your adjusted basis in the cryptocurrency is $10,000, you will recognize a $40,000 long-term capital gain. Generally, your gain or loss is the difference between your adjusted basis in the cryptocurrency and the fair market value of the goods or services you receive in exchange for it.

Fork in the road

In some cases, a cryptocurrency owner may recognize taxable income as a result of certain blockchain events. Taxable income may be triggered even if you do not conduct transactions or take any other actions with the cryptocurrency.

Recent IRS Revenue Ruling 2019-24 addressed the tax implications of two types of blockchain events: "Hard forks" and "airdrops." A hard fork occurs "when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger." Put much more simply, it is when a single cryptocurrency is split in two.

A hard fork may or may not be followed by an airdrop, which the IRS describes as "a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers." According to the ruling, when an airdrop follows a hard fork, it "results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency." In simpler terms, it is when "free coins" representing the new cryptocurrency are dropped into the existing cryptocurrency wallets of the owners of the legacy cryptocurrency.

If the new cryptocurrency is not airdropped or otherwise transferred to an account of the legacy cryptocurrency's owner, a hard fork does not trigger taxable income. On the other hand, if a hard fork is followed by an airdrop (which enables owners to immediately dispose of the new cryptocurrency), the owner recognizes ordinary income in the year the new cryptocurrency is received.

Stay current

Remember that buying and selling cryptocurrency involves significant risk, including the risk that you could lose part or all of the money you have invested. Tax treatment of cryptocurrency is also subject to change. The IRS is expected to provide additional guidance in the coming months and years on the unique tax issues cryptocurrency presents. Your ORBA advisor can help keep you current on these developments and work with you to avoid unnecessary risk and unpleasant tax surprises.

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.

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