The popularity of cryptocurrencies continues to soar across the globe. For US investors, the biggest trouble comes every tax season as cryptocurrency holders struggle to figure out how much they owe the government in taxation. Fortunately, the Internal Revenue Serve (IRS) announced last month that they are soon issuing new guidance on the taxation of cryptocurrencies. Since the initial notice issued in 2014, no substantial regulatory framework has been crafted to manage crypto taxation.
According to the original IRS guidance, the taxman treats virtual currencies like Bitcoin as property and not a currency. This left many questions unanswered. For instance, how do you value coins received as income? Over the recent years, the situation has become even more complicated. The emergence of phenomenon like forks and airdrops that issue free cryptos makes it difficult to handle the issue of taxation.
IRS Tax Policy Changes
According to IRS Commissioner Charles P. Rettig, the forthcoming guidance seeks to address the challenges facing the taxation of crypto assets. The major areas where the new IRS tax policy changes seek to address include:
Determining how much the crypto investors gained
Since the publication of IRS’ first notice, the biggest question that keeps cropping up is how taxpayers can determine the fair market value of coins received as income. Today, many companies pay freelance workers in Bitcoins. Many merchants also receive payments in bitcoin for goods or services rendered. So, it is a cost basis. According to the 2014 guidance, if an exchange lists a crypto, they calculate the fair market value by converting it to US dollars. They then determine the exchange rate reasonably and apply it in a consistent manner.
Now, the challenge is that cryptos can widely vary in value across multiple exchanges. And, every exchange has its own pricing methodology. So, using ten different exchanges means ten different pricing models. The American Institute of Certified Public Accountants (AICPA) suggests that taxpayers should be allowed to use three scenarios. They can choose to use the average exchange rate for different exchanges, or the average rate of the day for a specific exchange, or a third-party exchange rate index. As long as taxpayers are consistent in using these methods, the taxation process should not be a problem.
Types of coins spent
Today, it is even trickier to determine the cost of each unit of crypto that you spent in a taxable transaction, like making a sale. Whenever you sell cryptos, it is important to identify the fraction you’re selling to determine the gain or loss. For other assets, it is pretty easy to do that. For example, when dealing with stocks trading, you can apply the average cost basis or FIFO (First in, First out) assumption. It simply means that you are selling the earlier acquired price of the stock. To determine the price, taxpayers take the value registered at the time of the initial purchase. If the IRS extends the same approach to cryptos, it can be very helpful in streamlining taxation. However, the challenge could be if the first price of the earliest acquired coin is zero. That happens if, for instance, the owner mined the coins.
Forks, airdrops, staking
Other than buying and selling cryptos, there is a new list of events that trouble taxpayers. They include forks, airdrops, and staking. These scenarios all involve people receiving cryptos on the account that they already hold certain coins. For example, if you held bitcoin on August 1, 2017, you could claim an equivalent number of Bitcoin Cash that was born that day. Every other cryptocurrency that subsequently split from the mother chain can offer free coins to the original coin holders.
So, how do these taxpayers handle the free coins? Experts believe that where fork happens, the holders of the original cryptocurrency may make no effort to possess the new coins and fail to get hold of them. In that effect, taxation should not apply. However, if they get a portion of the new coin and sell it, it should be taxable at the time of sale.
Again, you can buy cryptos and keep them with custodial exchanges. So, any action that the exchange takes that leads to forked or airdropped coins should not affect you. The only exception is when you authorize the actions.
In a document submitted to the IRS in March 2018, the American Bar Association suggested a different approach to handling forks. They proposed that any taxpayer who owned coins that were subject to a Hard Fork in 2017 should understand that a forked coin is a taxable event. The value of the coin is considered zero. That means that the coins are earning zero dollars in income at the time of the fork. So, the fork itself is not a tax liability. But, if you sell the forked coins, you’ll be taxed on the entire proceeds of the transaction.
The concept of like-kind exchanges
Some schools of thought believe that cryptocurrency trades should be classified as like-kind exchanges. This approach could provide a manageable solution for crypto taxation, although the subject is always controversial. The IRS mentioned this concept in the IRC Code Section 1031.
If you sell a business or investment property at a profit, you must pay tax on the gain at the time of sale. But, IRC Section 1031 gives an exception and allows you to postpone the taxation if you choose to reinvest the gain in a similar property. In the crypto world, like-kind exchange means allowing taxable events to occur only when exchanging cryptos for fiat currencies. So, when you buy ethereum with bitcoin, you won’t trigger a taxable event. But if you exchange ethereum for fiat, you will have to pay the tax. In other words, taxation would only occur on the gains made when trading cryptos for fiat. The taxable amount is based on the value of fiat initially invested.
What does the future hold?
There are several other issues that the upcoming IRS tax policy changes seek to address. For example, buying, selling, and storing cryptocurrencies on exchanges registered overseas is a big concern. With fiat currencies, US citizens are obligated to file a Report of Foreign Bank and Financial Accounts (FBAR). That applies for all accounts holding more than $10,000. Again, if you hold financial assets worth more than $50,000, you must report them under the Foreign Account Tax Compliance Act (FATCA).
Now, the question is. Should these rules apply to cryptos? AICPA maintains that this should hold true for cryptos as well. They say that the taxpayers should aggregate the value of cryptos held abroad with the equivalent fiat value and report the same under FBAR and FATCA. However, if the taxpayers keep their coins in personal wallets, the cryptos should be considered as cash. That way, no FBAR or FATCA compliance would be required.
As we wait for the determination of IRS on these issues and many more, it is clear that crypto taxation will remain a controversial subject. People increasingly use cryptos to make small transactions like buying goods and services across the internet. If taxpayers report these as taxable events, it discourages many crypto holders from spending their coins. So, if the IRS can exempt small transactions from this policy, we could see widespread adoption of cryptos as digital cash.