Transactions in virtual currency are taxable just the same as transactions in U.S. currency, and if your client is transacting in virtual currency they may need to report these transactions on their tax return. Virtual currency is also referred to as "cryptocurrency".
Virtual currency is a form of "digital asset", a digital representation of value that can function as a medium of exchange, a unit of account, and/or a store of value. In addition to virtual currency, digital assets include stablecoins and non-fungible tokens.
For tax purposes, how is virtual currency treated?
Virtual currency is not legal tender in any jurisdiction, but there are tax consequences to converting virtual currency into real (or "fiat") currency or for using virtual currency to pay for goods and services. For federal tax purposes, virtual currency is treated as property, and the tax principles applicable to property transactions apply to virtual currency transactions.
How are virtual currency transactions reported to the taxpayer?
An individual paying virtual currency must report the payment on a tax document such as Form 1099-B, Form 1099-MISC (if the amount is $600 or more), or Form W-2 (if considered wages). However, the recipient taxpayer's responsibility to report a transaction involving virtual currency is not contingent on whether or not they received a tax document related to it.
How does the taxpayer report virtual currency?
An individual receiving virtual currency as payment for goods or services must report the fair market value of the currency received in their gross income. (The taxpayer can use a blockchain explorer to establish the fair market value.)
Note: As with any other transaction, if the taxpayer can't prove the purchase date and/or the basis, the transaction gain or loss is treated as short-term with a basis of $0.
Additionally, an individual who mines virtual currency in order to make a profit may be deemed to be operating a trade or business and thus be considered self-employed, requiring the payment of self-employment tax.
When trading virtual currency, whether or not a gain or loss is classified as a capital gain or loss or an ordinary gain or loss depends on whether the virtual currency is considered a capital asset similar to stocks, bonds, and investments, or other than a capital asset, such as, for example, inventory held for sale to customers.
As with stocks and similar investments, the basis includes fees and commissions. The currency in the wallet is traded on a first-in first-out basis unless it is specifically identified in the transaction.
The virtual currency / digital assets question
on Form 1040 / Form 1040-NR
The virtual currency question first appeared in tax year 2019, printed on Schedule 1 (Form 1040). Beginning in 2020 this question was moved to the top of Form 1040 and also added to the top of Form 1040-NR, evincing its importance to the IRS. Additionally, in 2022 the question verbiage changed, referring to the broader category of digital assets rather than just virtual currency.
The virtual currency / digital assets question is as follows:
- 2019-2021: "At any time during 20xx, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?".
- 2022 and forward: "At any time during 20xx, did you: (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?"
Answering the digital assets question No
The taxpayer can answer the digital assets question No if their activity was limited to these scenarios:
- They weren't involved in any way with digital assets.
- They held virtual currency in a wallet but did nothing with it.
- They transferred virtual currency from one of their wallets or accounts to another of their wallets or accounts.
- They used real currency to purchase virtual currency.
- They received virtual currency as a bona fide gift and did nothing with it.
- Their virtual currency either (a) went through a soft fork or (b) went through a hard fork but they didn't receive any new currency as a result.
Answering the digital assets question Yes
The reasons why the digital assets question will need to be answered Yes include, but aren't limited to, the following:
- They received or used virtual currency as payment for goods or services. This includes engaging in specific activities that earn virtual currency payments, such as responding to a promotion, completing an online survey, or providing a real or virtual good or service.
- They sold or otherwise disposed of an interest in virtual currency.
- They received virtual currency as a result of mining, staking, or validating.
- They received or transferred virtual currency without providing any consideration but that does not qualify as a bona fide gift.
- They exchanged virtual currency for some other property, including other virtual currency.
- They received new virtual currency as a result of a hard fork.
Navigation in TaxSlayer Pro
TaxSlayer Pro desktop - the digital currency question is asked in the individual tax return here:
- Personal Information
- Has Financial Interest in Any Virtual Currency - Select YES or NO as appropriate.
TaxSlayer ProWeb - the digital currency question is asked from the Federal Section of the individual tax return here:
- Basic Information
- Personal Information
What kind of tax document did the taxpayer receive
related to virtual currency?
- W-2 - Enter as a W-2 in the Wages section of the return.
- 1099-MISC, 1099-K - Presumably the taxpayer trades in virtual currency, so this income will be reported on Schedule C.
- In TaxSlayer ProWeb, enter the income from either document directly in Schedule C.
- In TaxSlayer Pro desktop, enter the 1099-MISC in its menu and link it to Schedule C, and enter the 1099-K directly in Schedule C.
- 1099-B, brokerage statement, or summary statement - Enter this information in the capital gain/loss menu. If the taxpayer's transactions are voluminous, they can use a blockchain explorer website and spreadsheet software as tools to summarize the information thus making it easier for you to enter it into the program.
- No tax document - You will need to ask the taxpayer questions about their virtual currency activity to determine (a) if it needs to be reported in the tax return and, if so, (b) whether the income or loss is related to wages, a business, capital gain or loss, or other income.
Note: This is a general discussion of virtual currency and the tax preparation process in TaxSlayer Pro. It is not intended as tax advice.
The following IRS references will aid in understanding the tax treatment of virtual currency and help you prepare the tax return for a taxpayer who engages in virtual currency transactions.
- IRS FAQ on Virtual Currency Transactions
- IRS: Digital Assets
- IRS Notice 2014-21 - Virtual currency guidance
- IRS Notice 2019-24 - Gross income after a hard fork or airdrop.
- Memorandum: Taxation of Virtual Currency Received in the Crowdsourcing Labor Market
- Memorandum: Bitcoin (BTC)/Bitcoin Cash (BCH) Hard Fork
- Memorandum: Applicability of Section 1031 to Exchanges of Bitcoin (BTC) for Ether (ETH), Bitcoin for Litecoin (LTC), and Ether for Litecoin
- IRS Fact Sheet FS-2007-18, April 2007, Business or Hobby? - Guidelines to help determine if a taxpayer's activity is a business or a hobby.
- Publication 525, Taxable and Nontaxable Income - Miscellaneous income from exchanges of property.
- Publication 544, Sales and Other Dispositions of Assets - Tax treatment of sales and exchanges of property, including the deductibility of losses.
- Publication 551, Basis of Assets - Determining the basis for property used in an exchange.