Virtual currency, also known as cryptocurrency or digital currency, is an online medium of exchange. Bitcoin is perhaps the most well-known virtual currency, but there are now more than 2,200 such currencies being publicly traded. According to CoinMarketCap, as of Oct. 22, 2019, the total global capitalization of cryptocurrency exceeded $223 billion. Virtual currency is being used for investment and accepted as payment for goods and services by a growing number of businesses. From a tax perspective, the rules for the taxation of virtual currency are emerging.

Overview

In 2014, the IRS ruled (Notice 2014-21) that virtual currency is property, not currency, and is taxed as such. For example, Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies. For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Taxpayers are required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.

If there is a sale or exchange of virtual currency, gain or loss is determined by this fair market value. If virtual currency is used to pay an independent contractor for work performed, this person reports income based on the fair market value of the virtual currency and must take this into account for self-employment tax purposes. The business that makes such a payment must report it on Form 1099-MISC (Form 1099-NEC for payments starting in 2020) if payments to the independent contractor for the year are $600 or more.

Certain Specific Transactions

The IRS has clarified the tax treatment for certain specific transactions involving virtual currency (Rev. Rul. 2019-24) and has posted FAQs on the subject. There is special terminology for these transactions.

Hard fork. A hard fork occurs in the creation of a new cryptocurrency on a new distributed ledger (a technology to record, share, and synchronize transactions) in addition to the legacy cryptocurrency on the legacy distributed ledger. In simple terms, there's a permanent diversion from the legacy distributed ledger. The IRS ruled that if cryptocurrency goes through a hard fork, but the taxpayer does not receive any new cryptocurrency, whether through an airdrop (explained next) or some other kind of transfer, there is no taxable income to report.

Air drop. An air drop is the distribution of units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. If a hard fork is followed by an airdrop and the taxpayer receives new cryptocurrency, the taxpayer has taxable income in the year that cryptocurrency is received.

Soft fork. This occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger so that no new cryptocurrency is created. Because soft forks do not result in the receipt of new cryptocurrency, the taxpayer is in the same position after the soft fork as before and no income results from the transaction.

Collectibles cannot be held in an IRA; a taxpayer who acquires them is deemed to receive a distribution in the year acquired. This is then treated as ordinary income and, if the taxpayer is under age 59½, subject to a 10% penalty. The acquisition is also treated as prohibited transaction (Code §4975(c)). Common collectibles include artworks, gems, and coins (Code §408(m)(2)). The IRS has not clarified whether virtual currency is or is not a collectible, although there are self-directed IRAs available for this purpose.

Tax Reporting

The IRS has added a new line to draft version of Schedule 1 of 2019 Form 1040 or 1040-SR that will be filed in 2020. This line, which has "yes" or "no" boxes to be checked, says: "At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?" The purpose of this new line seems to give the IRS a better idea of the prevalence of cryptocurrency transactions. (The line could be changed in the final version of the tax return.)

Draft instructions to Schedule 1 say that reportable transactions include:

• The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or following a hard fork;
• An exchange of virtual currency for goods or services;
• A sale of virtual currency; and
• An exchange of virtual currency for other property, including for another virtual currency.

The transaction is reported according to usual tax rules related to property. For example, a taxpayer who sold virtual currency held for investment must report the transaction on Form 8949 and Schedule D (Form 1040 or 1040-SR).

It appears that virtual currency transactions may not have to be taken into account for FBAR reporting (FinCEN Form 114, Report of Foreign Bank and Financial Accounts), at least for now. Virtual currency transactions are not specifically "reportable transactions." 31 CFR §1010.350(c). If virtual currency is held in Coinbase, which is a wallet for cryptocurrency, the "coins" are in the United States (i.e., not a foreign financial account). But the general question of reporting for FBAR purposes is still unclear; the IRS has not issued formal guidance on this matter.

IRS Letters

In 2018, the IRS began a Virtual Currency Compliance Campaign to encourage reporting of virtual currency transactions and examine taxpayers who fail to do so. This past summer, the IRS began to send letters to more than 10,000 taxpayers identified as failing to report virtual currency transactions in tax years 2013 through 2017 (IR-2019-132, 7/26/19). Three types of letters were sent:

• Letter 6173: This letter advised of the need to report transactions omitted from returns filed for these years. The recipient was required to respond by a set date, including the completion of a signed statement.
• Letter 6174: This letter also advised of the need to report transactions, but no direct response was required.
• Letter 6174-A: This letter also advised of the need to report transactions. Again, no direct response was required.

Whether or not a taxpayer received a letter, virtual currency transactions should be reported. In the upcoming tax season, it is expected that tax return preparers will be more attuned to the need to inquire about virtual currency transactions and report them accordingly.

Conclusion

The first cryptocurrency—Bitcoin—was launched in 2009. A decade later, there is still uncertainty about some tax matters involving virtual currency.

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company.