The use of virtual currencies has become more and more widespread in recent years, especially in the Silicon Valley area. Many people and businesses invest in and trade cryptocurrencies and use them to make purchases or pay employees. As financial activity in this area continues to increase, the IRS has taken note, and it is taking steps to make sure taxpayers properly report these transactions and pay applicable taxes on the income they earn and the gains of their investments. Some recent developments have shown that those who own virtual currencies will want to make sure they are meeting the requirements under the tax laws.

IRS Clarifies Reporting Requirements for Virtual Currency

Those who have begun to file their tax returns for 2020 may have noticed that a new question has been added to Form 1040 asking “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” This indicates that the IRS will be monitoring these transactions and taking action to collect taxes that are owed. However, taxpayers have faced some uncertainty about exactly what types of transactions need to be reported. Recently, the IRS offered some clarification by stating that those who purchased cryptocurrencies using “real” currencies do not need to answer “yes” to this question. 

For other types of transactions, virtual currencies are treated as property. When selling or exchanging cryptocurrencies, a taxpayer will need to recognize any capital gains or losses based on their basis in the cryptocurrency (the amount paid to acquire it, including fees or commissions) and the amount they received in exchange for the virtual currency. Those who receive cryptocurrency as wages or as payment for services must treat the virtual currency as income based on its fair market value at the time it was received.

The IRS pays close attention to taxpayers’ income and financial transactions, and there are a variety of reasons it may conduct tax audits. In recent years, virtual currencies such as Bitcoin have been a growing concern for the IRS, and many cryptocurrency owners have received notices regarding their requirements for reporting transactions involving these currencies. This scrutiny is likely to increase in the future as the use of virtual currencies becomes more widespread. In fact, the IRS released a draft of the 1040 tax form for 2020, and one of the first questions that is included on this form is “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” This indicates that those who own or trade cryptocurrency may face audits if they do not meet their requirements for reporting transactions and paying applicable taxes.

Tax Issues Related to Virtual Currency

Even though cryptocurrencies may be used similarly to currency issued by the United States or other countries, they are not recognized as legal tender. Instead, virtual currencies are considered property, and taxes may apply to transactions involving these currencies. If a person receives virtual currency in exchange for performing services, either as an employee or an independent contractor, this will be considered taxable income.

When virtual currency is sold or exchanged for other property, a taxpayer will be required to report gains or losses on a federal income tax return. These gains or losses are calculated by comparing the taxpayer’s basis in the virtual currency, or the fair market value of the currency at the time it was acquired, with the amount received in exchange for the virtual currency. Capital gains taxes may apply to gains made when selling virtual currency, and a taxpayer may be able to deduct losses in these transactions.

The Internal Revenue Service (IRS) has no plans to create a voluntary disclosure program for virtual currency similar to what has previously been offered for undisclosed foreign assets, an agency official recently said in a speech at a tax symposium.

In 2014, the IRS stated that cryptocurrencies such as Bitcoin that could be converted to traditional currencies are considered property for the purposes of taxation. Thus, a person may experience a gain or a loss when selling or exchanging cryptocurrency based on the value of the cryptocurrency at the time of the exchange. 

Because cryptocurrencies are classified as property, general taxation rules of property will apply. The sale of cryptocurrencies, the use of them to purchase goods or services, or retaining the cryptocurrencies for investment purposes generally have tax consequences, which may mean taxes will be owed.

Bitcoin, a digital currency, has gained popularity and utility in the last few years. Released in 2009, Bitcoin has been lauded as a superior currency accepted throughout the world and able to be transferred more efficiently than traditional denominations.

Bitcoin and other digital currencies like Ethereum are based on a technology called the blockchain. The blockchain is a digital ledger that keeps track of economic transactions. The blockchain has recorded every Bitcoin transaction that has ever occurred, for example.

The blockchain is considered incorruptible because it is publicly available and not stored in a central location. Instead, copies of the ledger are constantly being updated and reconciled on millions of computers across the world. Without this technology, cryptocurrencies would not maintain their integrity.