More investors than ever are contemplating adding virtual currency to their portfolio. Whether you are curious about Bitcoin, Ethereum, Facebook’s recent entry Libra, or any of the thousands of other virtual currencies available now, you may be thinking it is time for you to add it to your portfolio. However, if you are contemplating owning virtual currency, or if you are selling or trading some that you already own, you need to establish a value in order to complete the transaction. Establishing the value of virtual currency may sound easy, but it can turn very tough, very quickly. There are valuation issues with virtual currency that can make determining the value a very complex calculation.
The IRS treats virtual currency transactions as property transactions. Virtual currency is sometimes called “cryptocurrency” or “convertible virtual currency”; for this discussion, we’ll consider them all alike. For virtual currency transactions, the same long-standing and court-tested transaction rules apply as if you were purchasing, selling, or trading property, real or personal. If you sell virtual currency for more than you purchased it for, you have a gain, and if you sell it for less, you have a loss. Gains and losses are either ordinary or capital, either short term or long term. In all cases, the value of the virtual currency is the fair market value of the virtual currency at the time of the transaction- simple, right? But when you actually complete a virtual currency transaction, we’ll see it isn’t always so simple.
Take as an example the transaction of purchasing a unit of cryptocurrency (usually referred to as a token or coin). If you purchase one coin for $1, it’s easy- the value of the coin is $1- the fair market value of the coin at the time of the transaction. If you sold the same coin 2 years later for $2, you would report a $1 long term capital gain. But suppose you didn’t sell it and instead, you purchased another coin 6 months later for $2- its value is $2. Now suppose a year later you trade 1.5 coins for a hamburger- did you complete a transaction using virtual currency? Yes. Did you have a gain or loss? Well, that depends on the fair market value of the hamburger, and on which coin you used! Did you use, for example, the $1 coin and ½ of the $2 coin, or the $2 coin and ½ of the $1 coin? Or will you choose 0.63321212 of the first coin and 0.86678788 of the second coin? (Bitcoin, for example, can be split to the 8th decimal point.) Does the hamburger usually sell for $1 or $5? Even if you know how much the hamburger usually sells for, how do you document that? Did you include a tip, or taxes? Remember, you had a virtual currency transaction and the IRS will expect you to report that on your tax return. As of this writing, there is no minimum amount- you are required to report every transaction.
Using that example as our base, you can see how virtual currency can be very hard to value even in a simple case. Now, consider that virtual currency can be purchased from a U.S. or foreign exchange, it can be purchased from another person, it can be traded for another virtual currency, it can be “mined” (a process of creating a virtual coin that did not exist before), it can be “hard-forked” (a process that results in a new virtual currency from a division of an existing virtual currency), and that you can actually receive it for payment of services you provide, and the level of complexity in valuing virtual currency transactions skyrockets. In addition, exchanges are not currently required to provide you with IRS Form 1099, (which reports your proceeds and basis for transactions of other types of assets for each tax year), but the IRS may require the exchanges to provide records of the transactions to the IRS! You are left on your own to make sure you have a complete and accurate record of your transaction.
There are many and significant issues in valuing virtual currency and we have only scratched the surface of the details. Virtual currency is still a new frontier for taxation, and it will take time for all the rules to be set. In the meantime, the IRS is stepping up enforcement activity and as proof of their seriousness in attacking virtual currency issues, they recently sent 10,000 tax notices to taxpayers that may have had under-reported cryptocurrency transactions. At Sciarabba Walker & Co., LLP, we have the expertise to help you deal with virtual currency issues and to help relieve any anxiety you might have regarding your taxes. Please contact us if you are concerned about your tax situation.
By Cliff Acheson, CPA