Investor interest in virtual currencies, also known as crypto currencies or digital currencies, has skyrocketed along with the price. Bitcoin that was selling for $734 in May 2016 touched a mid-day high of $2,800 per unit a year later.
The IRS published some guidance in Notice 2016-14, and most importantly defined the virtual currencies convertible to US Dollars or foreign currency to be commodities and not currencies for income tax purposes. You can download a copy of the document by clicking on the pdf icon to the right.
The IRS Notice raised many questions that were posed in a letter from the AICPA to the IRS Commissioner (see pdf to download.) As yet, no response has been issued by the IRS.
Even the Treasury Inspector General got in the act with their own report on virtual currency taxation (see pdf to download.) The IRS agreed that more guidance was needed but it was not a high priority at this time.
Basic questions to ask to determine cost basis and tax treatment are:
1. Was it held as an investment (a capital asset) or as an inventory item (by a miner or trader)?
2. Was it sold or bartered for a real world good or service?
If the virtual currency is being mined or held as inventory in a trade or business, the regular accounting rules for business activity apply and revenue from the sale is ordinary income. For mining operations, revenue is recognized at fair market value when the coin is created and the expenses of mining (electricity, electronic equipment, etc.) become costs of goods sold.
If the convertible virtual currency is received in payment for a real world good or service, revenue is recognized at fair market value when the coin is received. Likewise, the recipient of a real world good or service that pays for it in the form of a convertible virtual currency must recognize capital gain sales proceeds equal to the fair market value of the virtual currency exchanged. This creates a capital gain or loss compared to the original cost basis of the tax lot used.
Not clearly addressed in the IRS guidance is whether a taxable transaction has occurred when one virtual currency held as a capital asset is traded for another virtual currency without being brought back into real currency form. It is the opinion of costbasis.com that this should be treated as a like-kind exchange under IRC Section 1031 and no taxable sale occurs until cash is realized. If more information is published by the IRS on this topic, this opinion will be updated as necessary.
Even more perplexing is the "hard fork" that occurred in Ethereum on July 20, 2016, when the Ethereum community cut off support for a previous chain due to faulty contracts. Holders of Ether units received an identical number of Ether Classic units and the previous Ether line became new Ether (although the name did not change.) What does that do to your cost basis you ask?
Costbasis.com is here to help! We have developed an Ethereum Fork Calculator to help you with this question. The general rule when you receive two new assets or securities in a non-taxable exchange for an asset or security you previously owned is that the cost basis should be apportioned to the new assets according to their relative fair market values. We have ascertained the cost allocation factors for the "Fork " event for you. Just click on the picture to the right to access the calculator.
Ethereum Fork Calculator
Another virtual currency cost basis action occurred on August 1, 2017 when Bitcoin Cash (ticker BCH or BCC) was issued by a splinter group to upgrade protocol and enhance capacity. Not all virtual currency exchanges agreed to support trading in the new Bitcoin Cash, but it traded on the Kraken exchange as well as many overseas exchanges, establishing a market value for cost basis allocation factors. Use our free calculator to compute your new cost basis for Bitcoin Cash and for the Bitcoin you continued to hold.
Exchanges such as Coinbase and GDAX that did not credit the Bitcoin Cash immediately have agreed to credit it later. Expected delivery is in January 2018. A Bitcoin holder at Coinbase could have moved their Bitcoin to Kraken to receive the Bitcoin Cash immediately. A case could also be made for computing the cost allocation factors based on the relative market values on the day that the Bitcoin Cash becomes available on the exchange where your own Bitcoins are held. Check back here for further developments on this topic.