How to think about taxes and cryptocurrency

As the 2018 tax season rapidly approaches, citizens in the U.S. may be left wondering how to properly report their cryptocurrency to protect themselves against legal repercussions from the Internal Revenue Service (IRS). In the past, reporting cryptocurrency to the government was regarded as little more than an afterthought given the lack of regulations. However, the IRS has repeatedly stated in recent months that they plan to keep a watchful eye on how cryptocurrency holders will be reporting their taxes.

Most notably, Coinbase, one of the leading exchanges for cryptocurrencies with billions of dollars exchanged on its platform, received a court order from the IRS in November 2017 to hand over information on all customers who had more than $20,000 in annual transactions on its platform between 2013 and 2015. This is estimated to total 8.9 million transactions impacting more than 14,000 different account holders, according to Forbes. In response to the order, Coinbase has now added tax reporting in the form of first-in-first-out (FIFO). This is a significant move toward the necessity of transparent reporting.

While the regulatory environment surrounding cryptocurrency is not mature at this moment, there are some basic guidelines that digital currency holders are advised to apprise themselves of as they enter tax season.

Cryptocurrency is not real tender

Those who hold coins might regard Bitcoin and other forms of cryptocurrency as money (traditional fiat currency), but that is a dangerous misconception in the current regulatory environment (or lack thereof) which is essentially in limbo. Treating cryptocurrency as legal tender would be ideal because any and every transaction utilizing cryptocurrency would not be regarded as a taxable event, which is incredibly cumbersome to report, especially when having to record past transactions. Irrespective of what's ideal, cryptocurrency isn't legal tender and all this digital money is viewed as "property" in the eye of the law. Like it or not, digital currency holders need to focus on reporting their gains and losses at the time of each transaction, whether coin-to-fiat currency or coin-to-coin.

In early 2014, the IRS released tax guidelines on cryptocurrencies and clearly spelled out that they are to be treated as property and not currencies. Since then, many countries and governing bodies like the European Union have followed suit. Treating it as property makes a lot of sense from the perspective of regulatory bodies. The blockchain is immutable, completely open to all, and every coin can be traced from its creation through its transaction history. This allows for the application of existing property laws to each tiny fraction of every coin as it makes its way through the blockchain from wallet to wallet. Bookkeeping this mess becomes an exercise in patience but remains possible. To maintain compliance the accounting approach must track and follow the coin's lifecycle.

What is considered a "taxable event" in cryptocurrency context

There are currently very broad guidelines as to what is considered a taxable event for cryptocurrency. Digital currency must be reported in a coin-to-fiat transaction, coin-to-coin transactions, or in the case of a purchase of goods or services using coin. A non-taxable event is the purchase of cryptocurrency with fiat currency, a transfer of coin between a wallet, and a gifting of it (assuming it doesn't exceed the limit of gift tax exemption and such a gift is allowable under the governing jurisdiction). With fiat-to-coin transactions, the USD value must be transcribed at the time of purchase to later report whether capital gains and losses are applicable. For example, if a digital currency holder purchased 3 Bitcoin for 30,000 USD, and then made a purchase or currency exchange with that coin within a year, it must be reported as a short-term capital gain or loss. If that same investment is held for one year or longer before being included in a qualifying transaction, it can be reported as a long-term capital gain or loss, which means taxes will be roughly half that of a short-term capital transaction. Keeping a detailed record of transactions with this specifically in mind is important to avoid a convoluted situation at time of filing.

The "gray area" of coin-to-coin transactions

Since the tax code for cryptocurrency is still largely being developed and remains fluid, there will be instances in which CPAs and digital currency holders alike will only be able to, at best, make smart assumptions. One of the most obvious examples where this is playing out is with coin-to-coin transactions. In the majority of ICOs today, trading for new alt-coins is tied to either Bitcoin or Ether. Most would file this under a like-kind exchange (meaning the coins are all considered the same type of property) but that may not necessarily be the case. Coins have different utilities and value and should not be categorized under the same broad umbrella.

A similar issue needs to be discussed in terms of forked blockchains. When Bitcoin forked to develop Bitcoin Cash, for example, it wasn't clear what changes may have occurred and how those needed to be adjusted on a tax form. Holders of Bitcoin suddenly found themselves with the same amount (not value) of Bitcoin Cash. Such an event is often referred to as an "air drop" and is out the direct control of the currency holder. Like it or not, you just received Bitcoin Cash.

When breaking down transactions into their components, some other technical gray areas emerge. Change, for example, is an unknown. Many transactions result in "change" that is returned to a wallet after it's complete. To illustrate, imagine handing a cashier a $10 bill for an $7.50 item. The cashier takes the $10 bill and returns to you $2.50; simple. The same behavior exists with cryptocurrency transactions. However, since these coins aren't currency and are treated as property, a cost basis must be applied to the change. Regulators are silent on this but the answer can drastically change a holder's tax liability. The answer may sound straightforward, but unlike the example with a $10 bill, cryptocurrency transactions often comprise multiple inputs with varying cost basis values and selecting which ones are used for change is largely subjective.

What is the easiest way to backtrack reporting

Cryptocurrency accounting and auditing services are popping up here and there now that regulators have shaken up the industry and struck fear into the minds of holders of cryptocurrency. Unfortunately, very few appear to have approached the problem properly and others are simply black boxes that spit out numbers with no explanation as to how they were calculated. Perhaps the worst approach is to apply trade strategies at bookkeeping time. First-In-First-Out (FIFO) or Last-In-First-Out (LIFO) must be considered when the transaction takes place, not after the fact. Not only does it not make sense to apply when calculating taxes, it's just plain wrong. We can just look at the blockchain and see exactly what happened. There is no need to pick FIFO or LIFO. The transaction is not a subjective event and it's unlikely a regulatory body will take kindly to misreporting when there is no ambiguity involved. Granted, it's a very difficult problem to solve, but difficulty doesn't absolve citizens from properly reporting their taxes.

Luckily, there are companies today that have taken the challenge of cryptocurrency head-on and have poured a lot of effort into applying property tax rules onto the blockchain and the best are able to track cost basis, the amount of time held, income, fees, and gains or losses for their customers and require minimal input.

Regardless of the which tax software you choose to use for tracking transactions, the results should be the same, or at least within a few dollars (rounding). The wild fluctuations in reporting across available services is a stark reminder that tracking value on the blockchain is much different than tracking assets. It's a huge challenge that if executed poorly, can result in wildly incorrect tax liabilities. Ultimately, the customer is responsible for accurate reporting. When selecting a service provider to help with cryptocurrency accounting, it is critical that the numbers produced by the software are backed up with clear worksheets that spell out all calculations used to arrive at a final gain or a loss. Such worksheets allow for a sanity check by the digital currency holder and can be provided to auditors when requested.

A second important consideration is methodology. Service providers should clearly articulate the methods used to track assets and value on the blockchain, and if those methods include FIFO or LIFO, be skeptical. Such strategies are not applicable, and under current US tax law, not allowed. Blockchain is a new technology, so we need to take a fresh approach and discard inappropriate accounting strategies ex post facto.

Many cryptocurrency experts have expressed that regulation in the market is inevitable given both the growth of the market and awareness of it. Regulation of the ICO market, intended to prevent fraudulent events and implement investor protections are well under way, but it is the tax legislation driven by the IRS that is going to hit first. As a digital currency holder, following these broad-based cryptocurrency tax rules, and consulting a CPA is essential to protecting yourself from an auditing nightmare this year and beyond as the IRS continues to update their tax rules.

2018 is shaping up to be the year of regulation and enforcement. While some may balk at government involvement, many of us in the industry see this as a stamp of approval, or at least an admission that outright banning is not practical and unnecessary. We must not forget what bitcoin developed out of; a mathematical solution to reaching consensus in a distributed environment. Blockchain is a new technology and it cannot be uninvented. Bitcoin was only its first application.

About the Author:

Sean Ryan is the Chief Technology Officer at HashChain Technology (TSXV: KASH; OTCQB: HSSHF) and co-founder and CTO of NODE40, LLC. An industry leader in the development of blockchain infrastructure services and cryptocurrency accounting, Ryan has an unparalleled understanding of how blockchain transactions work. Sean has designed and developed software for a variety of industries since 2000. His passion for data modeling and software architectures has led to successful stints in State government, nonprofits, and the private sector. At NODE40, Sean manages server-side development and a cloud-based infrastructure with an emphasis on security and privacy.