The ABCs of the Taxation of Virtual Currency

With new technologies come new forms of assets and, eventually, new rules for the regulation and taxation of such assets. Beyond the current frontier lies the land of the digital assets—cryptocurrencies, non-fungible tokens, and the like—that have become increasingly popular over the past several years. This article covers the basics of digital assets, with a focus on the valuation and taxation of digital currencies.

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Digital assets have gone mainstream. Yet despite their popularity as investments, as well as their use in commerce, the IRS has issued sparse guidance with respect to the taxation of virtual currencies and digital activity in general. Nevertheless, taxpayers must sift through what is available in order to determine when and to what extent their digital activity is reportable and/or taxable.

Although the primary focus of this article is the taxation of virtual currency (e.g., Bitcoin, Ethereum), the general term “digital asset” is quite broad in application. Virtual currencies, along with pass-through and asset backed tokens, nonfungible tokens (NFT) and a myriad of other Web3 holdings are all referred to in the aggregate as digital assets.

Definition of Virtual Currency for Tax Purposes

The IRS has defined virtual currency as a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value,” and has further ruled that cryptocurrency is property as opposed to currency (IRS Notice 2014-21). As such, the tax rules applicable to property transactions in general apply to transactions using virtual currency—as opposed to the detailed and targeted statutory framework surrounding the taxation of commodities and fiat currencies.

Determination of Market Value

Depending on the context, the market value of a virtual currency or other digital asset may first need to be determined in order to properly report taxable income from a particular digital transaction. For example, when an investor exchanges one virtual currency for another, or a virtual currency is used to pay for the purchase of an NFT, the tax rules applicable to “barter” transactions involving the exchange of property (or services) would apply. This means generally that the unrealized appreciation in any assets exchanged is immediately taxable as a result of the transaction. In these instances, the market value of the exchange (presumably equal on both sides) must be pegged in order to arrive at the proceeds received, which in turn is necessary for the computation of the taxable gain to be realized by each side. Note that the barter of digital assets does not qualify for IRC section 1031 like-kind exchange treatment, as such exchanges have been limited to real estate since the 2017 Tax Cuts and Jobs Act (see also ILM 202124008).

Investors

When individuals already in possession of virtual currency sell their holdings, they report their gain or loss as they would upon the disposition of any other asset. The gain or loss is determined by subtracting the tax basis in the asset sold from the proceeds received. (All amounts for U.S. tax purposes are reported in U.S. dollars.) Capital gain or loss is short-term or long-term, depending upon how long the virtual currency has been held. The former is taxable at ordinary income rates, whereas the latter is taxable at preferential long-term rates.

The Form 1040 virtual currency question. Starting in 2019, a new question was added to the Form 1040, requiring either a “yes” or “no” answer. The question reads: “At any time during 20XX, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” Some tax professionals believe that leaving the answer blank could conceivably delay processing, the receipt of a refund, or even raise the audit profile of a subject tax return. But note that the IRS has indicated that the mere purchase of virtual currency during a subject tax year does not require a “yes” answer to this question (IR-2022-61, March 18, 2022).

Businesses

Crypto-friendly businesses are increasingly accepting virtual currency as payment for the goods or services they provide, in addition to using it to pay employees, independent contractors, and suppliers. In such cases, the tax reporting would be handled in the same manner as where payments or receipts are made with other types of property, as opposed to with traditional currency. The amount of the payment or receipt thereof would be recorded using the market value of the virtual currency at the time of the transaction. Whenever virtual currency is used to pay an expense, or alternatively is received as payment, the unrealized appreciation or depreciation inherent in the transferred currency is realized for tax purposes

For example, the medium in which remuneration for services is paid is immaterial to the determination of whether the payment constitutes wages for employment tax purposes. Thus, the fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to FICA and FUTA tax and is reported on the employee’s Form W-2, Wage and Tax Statement.

Once an employee receives the compensation in a taxable transaction, they take tax basis in the virtual currency equal to the amount of income recognized. From that point forward, the employee essentially becomes an investor in the property that was received, subject to capital gain rates on any gain or loss recognized upon ultimate disposition. Also, as previously noted, for tax purposes the employer would be forced to recognize any inherent gain or loss in the virtual currency used to pay those wages.

On the revenue side, any cash basis business that is being paid in virtual currency for services, sales, or otherwise, would recognize ordinary income upon receipt. The receipt would be taxable as of the day received (typically upon deposit into the business’s online wallet), and in the amount equal to its market value at that time. The business would take a tax basis in the asset equal to the market value upon receipt. If the business decides to retain the virtual currency, similar to the employee in the previous paragraph, it would be treated essentially as an investor in the asset from that point forward.

Special Situations

Hard forks? Soft forks? Airdrops? What are these crypto terms? They represent special situations for which the IRS has actually provided clear guidance (Revenue Ruling 2019-24).

Recent Developments

At present, virtual currency cannot be used to pay federal tax obligations. But several states are moving in this direction. For example, in early March of this year, Colorado enacted a measure to accept payment in virtual currency for income taxes and certain licenses and permits (although when this will begin is as yet uncertain). Wyoming passed a bill to authorize the creation of a state-issued “stable token,” a form of digital currency. Florida is also working on allowing businesses to pay their taxes in virtual currency.

The Department of Labor (DOL) issued guidance (Compliance Assistance Release 2022-01, 3/10/22) cautioning fiduciaries to “exercise…