Crypto is a term used for electronic peer to peer ledgers that keep ownership and transaction records (referred to as “assets”). The first and best known example is bitcoin. Thousands of such ledgers are in existence with hundreds popping up every month. They can be copied (forked) from another or created from scratch, distributed free of charge or sold to the public. The ledgers are usually supported by computing powers of participating machines (nodes) in a process called “mining” (or “staking,” depending on the algorithm). Mining is incentivized with asset rewards, and so the system keeps running.
Because such networks operate in an autonomous manner, without a clearinghouse or any other intermediary, more popular, secured, and functional ones rise in value in relation to the government issued currencies. This fuels interest from investors and prompts technological and business innovation.
An ownership of a record on a ledger constitutes an ownership of an electronic property, according to the tax authorities in the US. When such record is traded for another record on another ledger, it is a tax event. Both parties to the exchange recognize gain or loss. The transactions are valued in US dollars at that instant and take place on various mostly centralized exchanges open 24/7.
If the original asset was acquired when its dollar value was lower, a gain is realized. Such gain is taxed less (by about one third) if the asset was held for more than one year (called long term gain). All the gains and losses in a year are netted.
US tax code exempts exchanges of like-kind assets under the famous code section 1031. This often comes up in the real estate transactions or when personal property (such as auto) is exchanged. Some intellectual properties could be considered of a like-kind in limited circumstances. Corporate stocks, however, cannot be traded tax free under this provision. Does swapping of a record in one electronic ledger (that’s what a crypto essentially is) for a record in another qualify here? The Internal Revenue Service (IRS - the main US income tax agency) has refused to explain under which circumstances it may or may not. An unsupported speculation would be to look into the underlying rights that such ledger entries represent. Bitcoin and Litecoin are almost identical in their make up and used for the exact same purpose. They don’t represent any functionality or ownership of any other asset but are used as a store or exchange of value. Ethereum, on the other hand, greatly differs from them as it has an enabled Turing complete programming language capable to support smart contracts and launch applications. Such difference could be subtler. While Ethereum features Solidity, others like Neo, Lisk, or Stratis deploy other tools in drastically varying ways. Similarly, a store and exchange of value functionality may or may not come with privacy features (Dash, PIVX, Nav) or even its own marketplace for buying and selling physical items or services (Syscoin). My official answer is that until we hear otherwise, all the trades are taxable.
Investors should evaluate their assets (including crypto) to consider year end moves to optimize. For example, the price of Bitcoin has risen. If it is exchanged for another crypto, a gain is realized. Other assets that have fallen in value may be exchanged as well, thus balancing out taxable gains. A mark to market election is available and can be beneficial if structured correctly. Although in constantly rising markets, it might be risky to make.
The new crypto issued for mining is taxable on its US dollar value at the time of the awards. Expenses related to the production of such income may be deductible and self employment tax may apply, depending on whether the mining effort is casual or run as a business.
A popular form of fundraising for a business project has been an initial coin offering (ICO) when a new crypto is created and sold to the public. Compliance with securities and money transfer laws is subject to clarifications but any such ICO is definitely a taxable event. When a crypto token is utilized for some functionality on a network (may be one can use it to run a software or buy online storage space or computing power), there might be ways under certain conditions when the taxation is deferred until the functionality is implemented. This helps greatly with matching the timing of income to expenses, thus eliminating an immediate need for cash outlays to pay the tax.
Communities can now easily issue their own cryptocurrencies for facilitation of transactions among the community members. Say a country club or homeowner association or non-profit organization. Transaction costs are zero on some platforms (e.g. Stellar Lumens), making proliferation of such coins a distinct possibility. With the right set of circumstances, such transactions might be exempt from taxation.
The crypto space has attracted scammer profiting from the lack of regulations and order. The schemes range from basic to elaborate ones. An example would be a website promising astronomical returns in exchange for borrowing and locking up crypto assets. After some time, the website becomes unreachable. Another example would be “pump and dump” coins when an asset is created primarily for selling it to as many people as possible, after which a project is abandoned. There may be others. As we discussed above, the crypto is taxed as property and the losses are normally capital losses. However, under certain conditions, it is possible to achieve an ordinary loss treatment so that the losses are deducted against other ordinary income, such as salary or business profits.
In my opinion, as this new tech advances, the congress should lower the tax on gains in the cryptosphere or at least simplify and clarify various points. We are still in the very beginning. Overly complicated reporting and excessive taxation, let alone vigorous enforcement, can hinder the progress with development and adoption by a wider population.
Speaking of enforcement, the effort by the IRS has been a determined one. It issued summons to Coinbase (the largest exchange and an entry point into the cryptosphere for the investors holding government issued currencies) to disclose its users trading above $20,000 from 2013 to 2015. The IRS claims that only 802 people reported crypto transactions on their tax returns in 2015 while millions of users are known to exist. It’s not clear how they can tell with certainty, just because notations on the tax forms might not fully and properly articulate what gains or losses are reported. There is no special place for crypto assets on the tax forms, at least yet. However, the fact that crypto asset trades are not reported to the IRS by the exchanges makes the tax authorities uncomfortable.
It turns out that it is easy to track a person’s activities in the cryptosphere. A New York based company Chainalysis (www.chainalysis.com) offers such services for large financial institutions, large businesses, and probably the IRS. More players are coming to this space as well. It is not clear to what extent privacy coins or coin mixing can be tracked, this remains to be seen. In any case, the entry points into a privacy coin can always be identified.
For an individual investor’s use, I found that https://cointracking.info/ (use my affiliate link https://cointracking.info?ref=B279916 for 10% discount) is the most advanced. You can enter APIs from your wallets or trading sites for convenient tracking of transactions and values. It generates tax report for the year as well. If you have found another good service, please, share it with us in the comment area.
Please, contact a trusted tax adviser for help in navigation through the maze of rules applicable to your case. I hope that this post will help you think of the right questions and better analyze your situation. If you don’t know whom to ask and are faced with significant issues, we are happy to help.
