IRS Releases “Frequently Asked Questions” and Revenue Ruling on Virtual Currencies
October 22, 2019
By Richard Shapiro
Building on a notice issued in 2014 (Notice 2014-21), the IRS has issued a list of frequently asked questions (“FAQs”) on virtual currency transactions. The FAQs expand upon examples provided in Notice 2014-21 and apply longstanding tax principles to additional situations. In general, the FAQs apply only to taxpayers who hold virtual currency as a capital asset.
In addition, the IRS recently issued Rev. Rul. 2019-24, which addresses the tax treatment of a cryptocurrency “hard fork” (described below).
As described by the IRS, virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange. Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency. The IRS uses the term “virtual currency” in the FAQs to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and “cryptocurrency.” Cryptocurrency is a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as blockchain. A transaction involving cryptocurrency that is recorded on a recorded ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.
The following summarizes responses provided by the IRS in the FAQs and Revenue Ruling on the tax treatment of virtual currencies.
Virtual Currency as Property
- Virtual currency is treated as property for federal income tax purposes, and general tax principles applicable to property transactions apply to transactions using virtual currency.
- Capital gain or loss, long-term or short-term, is recognized on the sale of virtual currency, subject to any limitations on the deductibility of capital losses. Holding period begins on the day after the virtual currency is acquired and ends on the day it is sold or exchanged.
- Gain or loss on the sale of virtual currency for real currency is the difference between the seller’s adjusted basis in the virtual currency and the amount received in exchange for the virtual currency.
- The cost basis in virtual currency purchased with real currency is the amount spent to acquire the virtual currency, including fees, commissions and other acquisition costs, in U.S dollars. The adjusted basis is the cost basis increased by certain expenditures and decreased by certain deductions or credits.
Virtual Currency and the Performance of Services
- Ordinary income is recognized on the receipt of virtual currency in exchange for performing services, whether or not performed as an employee. The fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax and Federal Unemployment Tax Act (FUTA) tax and reportable on Form W-2. In an on-chain transaction, the virtual currency is received on the date and time the transaction is recorded on the distributed ledger.
- In the case of services performed as an independent contractor, the fair market value of virtual currency received for services performed, measured in U.S. dollars, is self-employment income and is subject to self-employment tax.
- The basis in the virtual currency received for services provided is the fair market value of the virtual currency, in U.S. dollars, when the virtual currency is received.
- If a person pays for services provided with virtual currency held as a capital asset, the payer will have capital gain or loss equal to the difference between the fair market value of the services received and the payer’s adjusted basis in the virtual currency exchanged.
Virtual Currency Exchanged for Other Property
- If virtual currency held as a capital asset is exchanged for other property, including for goods or for another virtual currency, capital gain or loss is recognized equal to the difference between the fair market value of the property received and the adjusted basis in the virtual currency exchanged. If, as part of an arm’s length transaction, virtual currency is transferred in exchange for property, one’s basis in that property received is equal to its fair market value at the time of the exchange.
- If property (other than U.S. dollars) held as a capital asset is sold or exchanged for virtual currency, capital gain or loss is recognized. If the property transferred in exchange for the virtual currency is not a capital asset, then ordinary gain or loss is recognized. The gain or loss is equal to the difference between the fair market value of the virtual currency when received (in general, when the transaction is recorded on the distributed ledger) and the adjusted basis in the property exchanged. One’s basis in the virtual currency received is the fair market value of the virtual currency, in U.S. dollars, when the virtual currency is received.
Cryptocurrency/Hard Fork/Airdrop/Soft Fork
- A “hard fork” occurs when a cryptocurrency undergoes a protocol change resulting in a permanent division from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. No gross income is recognized if the cryptocurrency goes through a hard fork but no new cryptocurrency is transferred, either through an “airdrop” or some other kind of transfer. An “airdrop” is a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses.
- If a hard fork is followed by an airdrop and new cryptocurrency is received, the recipient of the new cryptocurrency has ordinary income equal to the fair market value of the new cryptocurrency when it is received, which is when the transaction is recorded on the distributed ledger, provided there is dominion and control over the cryptocurrency so that it can be transferred, sold, exchanged or otherwise disposed. Basis in the new cryptocurrency is equal to the amount included in income for federal income tax purposes.
- A “soft fork” of cryptocurrency owned does not result in income. A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and, accordingly, does not result in the creation of new cryptocurrency. The owner of the cryptocurrency in this case is in the same position as prior to the soft fork.
Cryptocurrency Exchange/Peer-to-Peer Transaction
- If cryptocurrency is received in a transaction through a platform for trading cryptocurrency, i.e., facilitated by a cryptocurrency exchange, the value of the cryptocurrency is the amount that is recorded by the cryptocurrency exchange for that transaction in U.S. dollars. If the transaction is facilitated by a centralized or decentralized cryptocurrency exchange but is not recorded on a distributed ledger or is otherwise an off-chain transaction, then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction.
- If cryptocurrency is received in a peer-to-peer transaction or some other type of transaction not facilitated by a cryptocurrency exchange, the fair market value of the cryptocurrency is determined as of the date and time the transaction is recorded on the distributed ledger or would have been recorded on the ledger if it had been an on-chain transaction.
Cryptocurrency with No Published Value
- If cryptocurrency is received in exchange for property or services and that cryptocurrency is not traded on any cryptocurrency exchange and does not have a published value, then the fair market value of the cryptocurrency received is equal to the fair market value of the property or services exchanged for the cryptocurrency when the transaction occurs.
Virtual Currency Received as a Gift
- If virtual currency is received as a bona fide gift, no income is recognized until the virtual currency is sold, exchanged or otherwise disposed.
- One’s basis in virtual currency received as a bona fide gift depends on whether there is gain or loss when it is ultimately sold or disposed. For purposes of determining whether there is a gain, basis is equal to the donor’s basis, plus any gift tax the donor paid on the gift. For purposes of determining whether there is a loss, basis is equal to the lesser of the donor’s basis or fair market value of the virtual currency at the time the gift is received. Absent any documentation to substantiate the donor’s basis, the donee’s basis is deemed to be zero.
- A donee’s holding period in virtual currency received as a gift includes the time the virtual currency was held by the donor. Without documentation of the donor’s holding period, the donee’s holding period begins the day after the gift is received.
Charitable Contribution of Virtual Currency
- If virtual currency is contributed to an IRC Sec. 170(c) charitable organization, no income, gain or loss on the donation is recognized by the donor. The charitable contribution deduction is generally equal the fair market value of the virtual currency at the time of the donation if the virtual currency has been held for more than one year. If the virtual currency is held for one year or less at the time of the donation, the deduction is the lesser of the donor’s basis in the virtual currency or the virtual currency’s fair market value at the time of the contribution.
Transfers Amongst Multiple Digital Wallets, Accounts or Addresses by Single Owner
- If virtual currency is transferred from a wallet, account or address to another wallet, account or address belonging to same person, that transfer is a non-taxable event, even if an information return is received from an exchange or platform as a result of the transfer.
Multiple Units of Virtual Currency Disposed/Specific Identification
- If multiple units of one kind of virtual currency with different holding periods and bases are held and some units are sold, exchanged or otherwise disposed, the units disposed can be specifically identified. A specific unit of virtual currency can be identified by documenting the specific unit’s unique digital identifier, such as a private key, public key, or address, or by records showing the transaction information for all units of a specific virtual currency, such as bitcoin, held in a single account, wallet or address. This information must show (1) the date and time each unit was acquired, (2) one’s basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged or otherwise disposed and (4) the fair market value of each unit when disposed, and the amount of money or the value of property received for each unit.
- Absent specific identification, units are deemed to be sold, exchanged or disposed in chronological order beginning with the earliest unit of the virtual currency purchased or acquired (i.e., first in, first out (FIFO)).
Reporting and Recordkeeping
- Income, gain or loss from all taxable transactions involving virtual currency must be reported on one’s federal income tax return for the taxable year of the transaction, regardless of the amount or whether a payee statement or information return (such as Form W-2 or Form 1099) is received.
- Capital gain or loss from virtual currency is reported in accordance with IRS forms and instructions, including Form 8949 (Sales and Other Dispositions of Capital Assets) and Form 1040, Schedule D (Capital Gains and Losses). Ordinary income from virtual currency is reported on Form 1040, Form 1040-SS, Form 1040-NR or Form 1040, Schedule 1 (Additional Income and Adjustments to Income), as applicable. Please note that the draft Form 1040, Schedule 1, just released, includes the following new question, to be answered by checking a “Yes” or “No” box: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
- Records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency should be maintained consistent with the general requirement that taxpayers maintain records sufficient to establish the positions taken on tax returns.