The virtual currency market is hot. In the first quarter of 2021, the value of Bitcoin more than doubled, from $28,994 per coin on January 1 to $58,919 per coin on March 31. A year earlier, on January 1, 2020, each Bitcoin was worth only $7,195. Some analysts predict that the value of Bitcoin could soon go as high as $100,000 per coin — others are less bullish, however.

The recent spike in value comes as Mastercard announced that it will allow merchants to receive payments in virtual currency; BNY Mellon Bank plans to hold, transfer and issue virtual currencies on behalf of its clients; and Tesla purchased $1.5 billion of Bitcoin and will start accepting Bitcoin payments for its products. But history has shown that virtual currencies can be volatile investments.

The IRS is watching closely as more people and businesses venture into the world of virtual currency. And those that fail to comply with the IRS’s complicated rules may find themselves in hot water. Here’s some guidance about how and when exchanges of virtual currency are reported for federal tax purposes.

Is Bitcoin a Currency or an Asset?

Bitcoin is just one of roughly 1,500 types of virtual currencies (also known as “cryptocurrencies”). Under current tax law, virtual currency is considered property for tax purposes. In other words, it’s not treated as a traditional currency that could generate foreign currency gain or losses

As a result of this classification, you must recognize taxable gain, income or loss every time you exchange virtual currency for goods, services, U.S. dollars or for a different virtual currency. Virtual currencies can be classified as business, investment or personal-use property.

Do I Have a Gain, Income or a Loss?

When you exchange virtual currency for other property, including U.S. dollars or a different virtual currency, you must recognize a taxable gain if the fair market value of the property you receive exceeds your basis in the virtual currency that you exchanged. That gain will qualify for a more favorable long-term capital gains tax rate if you’ve held the virtual currency for more than a year — if not, the gain will be taxed as ordinary income. The holding period begins on the day after you acquired the virtual currency and ends on the day you sell or exchange the virtual currency.

You may have a loss on an exchange if the fair market value of the property you receive is less than your basis in the virtual currency. However, depending on the circumstances, you may be limited in how much you can deduct in the current tax year.

Likewise, workers who receive virtual currency for rendering services must report the transactions as taxable ordinary income. Employees will receive a W-2 for virtual currency payments from their employers, and the wages will be subject to payroll tax withholding. Independent contractors will receive a 1099 for virtual currency payments, and they must pay income and self-employment taxes on those receipts. The amount on the worker’s W-2 or 1099 will establish his or her tax basis in the property when it’s sold or exchanged in the future.

How Are Gifts and Donations Taxed?

Taxpayers who receive virtual currency as a bona fide gift aren’t required to recognize a gain or income until the property is sold, exchanged or otherwise disposed of.

Alternatively, if you donate virtual currency to a charity, you can claim an itemized deduction for the charitable contribution, generally equal to the fair market value of the property at the time of donation. However, if the virtual currency has been held for one year or less, the deduction is limited to 1) the lesser of the property’s tax basis, or 2) its fair market value at the time of donation.

Which Transactions Must Be Reported?

There’s a common misconception that you must report all virtual currency transactions on your Form 1040. While it’s true that there’s a question about virtual currency on the front of your 2020 tax return, simple cash purchases of virtual currency aren’t a taxable event, according to recently updated FAQs on the IRS website. (But you’ll need this information to establish your tax basis when the virtual currency is later sold or exchanged.)

Furthermore, the instructions for Form 1040 state, “A transaction involving virtual currency does not include the holding of virtual currency in a wallet or account, or the transfer of virtual currency from one wallet or account you own or control to another that you own or control.”

However, there’s a new question on the front page of the 2020 Form 1040 to let the IRS know if you “receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency” in the current tax year. It’s important to maintain detailed records about virtual currency transactions to help determine the property’s fair market value when received and exchanged and to establish your tax basis in the property.

More Questions

These are just a few common questions about virtual currency transactions. The reporting requirements can be complicated, especially if you engage in a high volume of virtual currency transactions or you have multiple accounts, wallets and addresses capable of holding virtual currency. Contact our tax specialists for more information.