Warning: It’s called ‘cryptocurrency’ but treat it like stock
With catchy names and compelling headlines about breathtaking increases and decreases in value, cryptocurrencies like Bitcoin, Ethereum, Litecoin and others are making many investors swoon.
While these assets have “currency’’ in the name – even the IRS calls it “virtual currency’’ – do not make the mistake of thinking it behaves like the dollars in your wallet. Yes, you can buy everything from cars to vacations with Bitcoin and the like, but there is a significant catch.
When you buy cryptocurrencies, you are not getting an asset that behaves like money, but something that under federal tax law gets treated like stock. You are required to account for every transaction and increased value realized on use of the cryptocurrency results in recognition of capital gains, which are subject to tax.
Thinking about using some Bitcoin profit to buy that new car you have been eyeing? When tax time comes, you may be paying more for the car because you may have income tax to pay on the gain realized on the liquidation of the cryptocurrency to pay for the car.
Here’s some advice to help you avoid turning your cryptocurrency investment into a financial headache:
The taxman cometh
As the popularity of Bitcoins took off over the past year, many accountants were wringing their hands about the tax filing nightmares ahead. Compounding the problem is that unlike stock, brokerage firms which provide year-end documents that track gains and losses, so far, the cryptocurrency exchanges are leaving the tracking up to clients.
Like everyone else, the IRS has taken notice of Bitcoin-mania. From 2013 through 2015, fewer than 900 people declared Bitcoin-related transactions on their taxes, despite the millions that obviously took place.
In 2016, the IRS ordered the major cryptocurrency exchange Coinbase to turn over the records of more than 14,000 account holders. A court battle ensued, and so far, the IRS is winning. And no one expects the IRS will stop with just this exchange.
Failing to report gains and losses realized from the use or sale of cryptocurrencies on your tax return can cost you dearly in back taxes and penalties. Criminal penalties are entirely possible if the IRS accuses you of knowingly filing a fraudulent return to hide gains.
The big takeaway is that you must save every transaction email or document and losses are as crucial as gains. For example, if you take a $30,000 loss in a Bitcoin sale but cannot prove it is a loss, the IRS will consider the proceeds from sale a taxable gain.
You therefore need some means by which you can track your purchases and dispositions. There are a few cryptocurrency tracking software programs and 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.
Now that some cryptocurrencies have fallen in value (or disappeared in fraudulent exchange transactions or hacking), you may be able to recognize losses when you sell cryptocurrency as well. Whether there is a gain or loss, you will need to know your adjusted basis in the fractional coins sold, used, or spent so you can correctly report the activity for tax purposes.
Purchase with caution
You may be familiar with short-term gains for stocks, where shares held less than a year are taxed at the ordinary income tax rate. In 2017, the rate can range from 10 to 39.6 percent.
Remember the car example above? Especially if you make a large purchase with cryptocurrency held for less than one year that has gone up in value, you could be looking at ordinary income tax rates on the gains on top of the usual sales taxes for your purchase.
That is why it is a misnomer to think of Bitcoins and similar assets at “currency.’’ Staying with the car example, if you are looking at substantial capital gains – which if not paid that tax year is subject to late payment penalties and interest – you may want to use cash or borrow money for the car instead of using your cryptocurrency.
A way to lower tax liability
If you are able to itemize your deductions and still claim charitable deductions, giving your appreciated cryptocurrency to a nonprofit can lower your overall tax liability.
Say you had $20,000 in Bitcoin that’s appreciated 200 percent (so it’s now worth $40,000). Instead of writing a check to the charity for $40,000, give $40,000 in Bitcoin, get the charitable deduction for $40,000 and avoid paying taxes on your gain on the cryptocurrency investment.
According to media reports, the IRS is using software to find cryptocurrency users who fail to report profits. If you are going to invest in Bitcoin and similar assets, keep track of your activity because it is a certainty the taxman will be watching.
Cryptocurrency may be worth a look for your portfolio, but my advice is that if you buy any, look at it as you would stock. Remember that you will be subject to tax at ordinary tax rates if you sell appreciated cryptocurrency less than one year after purchase. As with all investment decisions, it is always a good idea to consult with your accountant and financial advisor.
There is little doubt that cryptocurrencies are here to stay and certainly people are making money from Bitcoins and the like. It requires careful record keeping and planning to make sure your cryptocurrency dreams do not turn into tax nightmares.
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