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Cryptocurrency - Understanding Virtual Currency and its Tax Implications

By Zac Crites and Mark Castro, CPA
Updated: February 15, 2022


What is Virtual Currency

Unless you have been hiding under a rock for the last couple of years (I don’t blame you), you are probably aware of or very confused by the term, virtual currency. The entire world has been scrambling to develop applications, technology, or just a basic understanding of what virtual currency is and/or how they can incorporate it into everyday life.

According to the Internal Revenue Service, “virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”

In simpler terminology, virtual currency is considered digital money that has a real-time value that can be used for multiple applications.

Bitcoins

Cryptocurrency

If you were one of the estimated 117 million viewers of Super Bowl LVI, you may have wondered why a floating QR code took over your tv for 60 seconds during the game.  Cryptocurrency is the reason for the retro DVD-designed ad space by a popular cryptocurrency exchange app called, Coinbase.

Cryptocurrency is a type of virtual currency that is typically decentralized and tracked by blockchain technology, also known as a digital ledger. Mainstream cryptocurrencies like Bitcoin, Ethereum, and Dogecoin are just the tip of the iceberg when it comes to cryptocurrency.  According to CoinMarketCap, more than 10,000 different cryptocurrencies are available as of February 2022. The cryptocurrency market operates similarly to the stock exchange in a way that you can purchase crypto for a specific value one minute and sell it the very next day for a different value. Also, it is becoming more and more popular to purchase either digital or even real-world items with crypto, essentially selling the crypto at the current value and purchasing the item at the same time.

According to an article published by si.com, high profile WR for the Super Bowl champion LA Rams, Odell Beckham Jr. received his one-year salary in Bitcoin via CashApp.

Confused yet? If not, get ready, because this phenomenon is changing the way the world does transactions and it doesn’t look to be slowing down.

NFTs

Starting in 2015, the new idea of a unit of data stored on the blockchain that certifies a digital asset was born, thus creating one of the most trending topics besides Covid-19 stats in 2021 – non-fungible tokens, better known as NFTs. This technology not only increased revenue significantly for digital artists across the globe, but also is transforming real-world transactions such as the real estate market. Now besides just displaying your latest NFT as your Twitter account profile picture, families purchasing their forever home can use the latest NFT technology to ink the deal.

NFT of Houses

According to an article by Coindesk, a four-bedroom Gulfport, Florida home was recently purchased via auction on blockchain startup Propy’s platform for $653,000 (210 ETH). The winning bidder was awarded an NFT as proof of the home’s ownership.

 

Virtual Currency Question on 1040

Yes or No

IRS is continuing its effort to make taxpayers aware of the tax consequences involving virtual currency by requiring all taxpayers to answer the following question on page 1 of the 2021 Form 1040:

“At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”

This question should be answered “Yes” for virtual currency transactions that include (but not limited to):

  • The receipt of virtual currency as payment for goods or services provided
  • The receipt or transfer of virtual currency for free (without providing any consideration) that does not qualify as a bona fide gift
  • The receipt of new virtual currency as a result of mining and staking activities
  • The receipt of virtual currency as a result of a hard fork
  • An exchange of virtual currency for property, goods, or services
  • An exchange/trade of virtual currency for another virtual currency
  • A sale of virtual currency
  • Any other disposition of financial interest in virtual currency

This question should be answered “No” in the following circumstances:

  • Taxpayer did not have any transactions involving virtual currency during 2021
  • The individual’s only transactions during 2021 involved holding virtual currency in a wallet or account
  • The individual’s transactions only involved the transfer of virtual currency from one wallet or account the individual owned or controlled to another they owned or controlled
  • The individual’s only transaction(s) involving virtual currency were purchases of virtual currency for real currency, including the use of real currency electronic platforms such as PayPal or Venmo.

If an individual answers the Virtual Currency question “Yes”, their virtual currency transactions will need to be correctly reported on their 2021 federal tax return as follows:

  • On Form 8949 to figure the capital gain or loss, if the virtual currency is disposed of through a sale, exchange, or transfer
  • On Form 1040, line 1, if the individual received virtual currency as compensation for services
  • On Schedule C, if the individual received virtual currency that they held for sale to customers in a trade or business

 

Virtual Currency

Tax Consequences of Using Virtual Currency

It is important to understand that for federal tax purposes, virtual currency is not considered to be legal tender. It is considered to be property. This means that when virtual currency is used to purchase goods or services, it is considered a capital transaction (similar to selling stock) which results in either a capital gain or loss. Therefore, these transactions must be reported on Form 8949 (Sales and other Dispositions of Capital Assets) which will then flow to Schedule D (Capital Gains and Losses) on the federal tax return.

In order to calculate the capital gain or loss, an individual must determine the purchase price of the virtual currency (the fair market value of the virtual currency when it was purchased or received) and the selling price (the fair market value when it was used to purchase goods or services).

If virtual currency is received by an individual for services or for the sale of goods in a business, it is considered ordinary income to the individual. This income must be recognized at the fair market value of the virtual currency at the time it was received. If the income was received as wages and reported on Form 1040, line 1, then the individual will receive a Form W-2. If it was for services performed or goods sold as a self-employed individual, then it would be reported on Schedule C, line 1.

When a self-employed individual uses virtual currency to purchase goods or services for their business, this transaction is not just an expense of the business it is also considered a capital transaction which will result in either a capital gain or loss.

One other thing to remember – if an individual received virtual currency for their services or for the sale of goods and they do not convert it to cash immediately, they will have a capital transaction when they do convert it at a later date.

See the following for more information on the tax consequences of cryptocurrency:

FAQ and Resources

For more details on how to report Virtual Currency Transactions see the following on the IRS website:

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