By David T. Mayes
Cryptocurrencies have been around for more than a decade. Bitcoin, the first cryptocurrency, launched in January of 2009 and its success has spawned more than a hundred competing digital currencies. The appeal of cryptocurrencies is unrelated to the fact that they can be used to pay for goods and services.
Most payments in regular currencies can be made digitally these days. Rather, it is the other features of digital currencies that make them appealing. Cryptocurrencies are decentralized meaning that there is no government controlling the amount in circulation. Consequently, there is no government that can expand the supply of Bitcoins causing their value to decline. This concern about governments "printing" money and triggering inflation was central to the runup in Bitcoin's price from the second half of 2020 to mid-May 2021.Cryptocurrencies also offer a fully anonymous and transparent means for transferring funds from one person to another.
But while cryptocurrencies may in some ways act like money, in other ways, they fall well short of being an efficient means of transacting business. Fundamentally, money has three features. It acts as a medium of exchange, serves as a store of value, and can be used as a unit of account. Investors who have shifted some of their portfolios into cryptocurrencies have likely done so because they believe them to be a good store of value. However, because the price of a Bitcoin can fluctuate widely from day-to-day, they do not work that well as a medium of exchange. Would you use Bitcoin to buy groceries if you thought that the price of your coins would go up 10% in value over night, or accept them as payment for goods if you thought they would decrease significantly in value in a short time?
In reality, cryptocurrencies are less like money and more like any other risky asset. Investors buy crypto because they expect its future value to be higher, much like they do a share of Apple or Google. This is how the IRS views things as well when it comes to the tax rules related to selling units of cryptocurrency or using them to make purchases. Make no mistake, the IRS has taken note of the growth in acceptance of cryptocurrencies is taking steps to ensure that crypto transactions are reported on tax returns.
The 2020 version of Form 1040 asked whether you had received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. Any of these events should have the IRS's systems looking for reportable income from cryptocurrency, either in the current tax year or a future year.
Because the IRS views cryptocurrencies as capital assets, computing the tax impact of crypto transactions follows the rules for capital gains and losses. Any time cryptocurrency is exchanged for US dollars, goods and services, or another cryptocurrency, gain or loss is recognized in the same way as if you sold a share of stock. Gain or loss is computed by taking the difference between the fair market value of the cryptocurrency sold or exchanged and its cost basis. Cost basis is the amount you paid for the cryptocurrency or, if received in payment for services provided, the fair market value of the virtual coins on the date you received them. This is the amount you would include in ordinary income for the tax year and, since this value gets taxed, it establishes your cost basis in the virtual coins. You have a gain if the fair market value of what you sold or exchanged exceeds its cost basis.
Otherwise, you have a loss. The gain or loss is short-term if the cryptocurrency sold was held for less than twelve months and long-term if the virtual currency was held for more than twelve months. Long-term gains are taxed at more favorable tax rates than short-term gains which are taxed as ordinary income.
So, the key to properly reporting gains and losses on cryptocurrency transactions is keeping track of cost basis for each unit of virtual currency. Maintaining good records in a spreadsheet will help.
Given that crypto investors are likely to acquire units at different times and prices, it may be possible to reduce gains or maximize losses when exchanging crypto by specifying which units of currency are being exchanged and focusing on disposing of those with the higher cost basis first.
David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Three Bearings Fiduciary Advisors, Inc., a fee-only financial planning firm in Hampton. He can be reached at (603) 926-1775 or [email protected].
David T. Mayes