Trading one cryptocurrency for another? Beware potential tax pitfalls…
As trading Bitcoins and other cryptocurrency explode in popularity, investors are playing with fire by failing to report their transactions as required by law.
According to the IRS, fewer than 900 people reported gains and losses from virtual currency transactions for tax years 2013-2015 despite reports of widespread trading. The vast under-reporting has prompted the agency to launch a task force to enforce compliance – and to mete out civil and possibly criminal penalties.
TRACKING PROFIT AND LOSS AT EVERY STEP
Perhaps less understood is that when trading one cryptocurrency for another, each trade must be separately documented and reported as a gain or loss transaction on your tax return.
That means if you use Bitcoin to purchase Ethereum, you need to figure out the value of your Bitcoin and track whether you were selling at a gain or a loss. Then you need to determine the value of the amount of Ethereum you are acquiring, and that becomes your basis for the investment. When you sell the Ethereum, that basis will determine if you have capital gains to declare or take a loss. If you decide to cash out, you need to determine the value of the Ethereum and, as before, figure out if you are declaring a gain or loss.
Notice that in the above example, we’re looking at three transactions to report on your tax return: Your initial Bitcoin purchase; trading the Bitcoin for Ethereum; and selling your Ethereum for cash.
Keep in mind that, as with stocks, the holding period determines if the gain/loss is short or long term.
Some early cryptocurrency investors initially thought they could apply a tactic often used with real estate investing to defer capital gains called a like-kind exchange (“LKE”). For Federal tax purposes, a LKE allows deferral of the gain under the Internal Revenue Code (“IRC”) § 1031. For example, a real estate investor who trades one property for another that is substantially similar in nature and use, the investor can report it as a LKE. In the event of a LKE, the investor defers paying tax on the capital gain until the sale of the new property.
- Pennsylvania never allowed like-kind exchanges, so you still need to account for each capital gain/loss transaction on your Pennsylvania income tax return.
- Before January 1, 2018, an IRC §1031 exchange is defined to exclude investment securities like stocks and bonds, so common investments were not eligible for LKE gain deferrals (losses are not deferred). The IRS construes cryptocurrencies as similar to stock, and therefore are likely not eligible for LKE treatment.
- As of January 1, 2018, only assets eligible for LKE treatment are real estate investments.
Bottom line: If you are investing in cryptocurrencies, track every transaction as you would stock and report those transactions on your tax returns.
Unlike stocks, where your brokerage sends you a 1099-B or a 1099-DIV for a mutual fund at the end of the year for tracking your profit and losses for tax purposes, cryptocurrency investors are on their own. Cryptocurrency exchanges do, of course, keep track of transaction histories, so it is up to investors to track their adjusted basis and holding periods to calculate their tax liabilities.
There are a few cryptocurrency tracking software programs, or you can try a money management program like Quicken. Many people will end up tracking in Excel. In any event, you need to be able to identify the adjusted basis of the fractional coins of cryptocurrency you use/sell/spend.
A WORD TO THE WISE
If you are one of the thousands of taxpayers who failed to report your cryptocurrency investments fully, now is the time to go back and figure out if you owe the IRS.
With the IRS pouring over cryptocurrency transaction records, you do not want to play audit roulette. Better to figure out what you owe and talk to an accountant about filing an amended return.
While you are talking with your accountant, look at whether you need to file a Foreign Bank Account Report (FBAR), a requirement for accounts that exceed $10,000 at any point in the tax year. Many virtual currency exchanges are offshore and may trigger FBAR reporting requirements.
If you decide to invest in cryptocurrencies, keep in mind that while you are focusing on potential profits, you also need to focus on proper record keeping. Just as with any investment decision, it is a good idea to consult with your accountant and financial advisor to make sure you comply with IRS reporting requirements and avoid any nasty – and expensive – surprises.
Benjamin R. Bostic, CPA, is a manager at Boyer & Ritter with experience providing tax and accounting services for individuals, not-for-profit, and closely held business clients. Reach Ben at 717-264-7456 or firstname.lastname@example.org