What You Should Know About the Taxation of Cryptocurrency

First and foremost, First Citizens Bank ("Bank") currently stands neutral on all cryptocurrencies and subsidiaries. The Bank doesn't offer or incorporate any cryptocurrency as part of any investment strategy or model, nor does the Bank endorse the purchase or sale of any cryptocurrency. Regardless, there's great interest around this subject, and we want to provide information on the possible tax implications of cryptocurrency. Please understand that the information in this article is for educational purposes only and shouldn't be considered tax advice. If you currently hold or are considering purchasing cryptocurrency, we recommend that you speak with a tax professional.

Some form of digital currency has been around since Digicash debuted in 1990. But it wasn't until the November 1, 2008, email from Satoshi Nakamoto, which invited recipients to use its new peer-to-peer electronic cash system called Bitcoin, that cryptocurrency really launched into the mainstream as a legitimate payment form. Today there are over 10,000 different types of cryptocurrency.

Cryptocurrency is defined as a digital or virtual currency designed to work as a medium of exchange. Transactions are verified and recorded in a decentralized system instead of a centralized authority. It uses encryption (thus the "crypto" in the name) to secure and verify transactions as well as to control the creation of new units of a particular cryptocurrency. Traditional currency such as dollars or sterling pounds is referred to as fiat money.

There are several differences between cryptocurrency and conventional or fiat money, but the main characteristics that separate them are the decentralized aspect and encrypted aspects of cryptocurrency.

A basic overview of how cryptocurrency works

Before we jump into its tax implications, let's quickly go over how cryptocurrency works. Cryptocurrency transactions are logged via blockchain, essentially a digital ledger held across a peer-to-peer network (not in one central repository). A generalized overview of the blockchain goes something like this:

1. A person creates a wallet (or an account funded with cryptocurrency using a software application) and requests a transaction.
2. The transaction is broadcasted to a network of computers, called Nodes.
3. The Node network validates the transaction and the user's status using known algorithms.
4. A person or group who uses computers to solve the algorithm and confirm the transaction is called Miners. They can be compensated for their work.
5. After confirmation, the transaction enters as a block in the chain of data along with other transaction blocks that make up the blockchain. Once added, the blocks are permanent and immutable.
6. The original person requesting the transaction now holds the digital currency and is referred to as a "Hodl" or is engaged in the act of "Hodling".

The whole network is secured with cryptography to ensure that all balances and transactions are both anonymous and safe. There are digital currency exchanges which trade traditional fiat money for digital currency, thus allowing a way to enter in and out of the market. With the wide array of digital currencies available, there may be some differences to the overview steps illustrated. Some currencies operate as Altcoins, meaning they're a separate currency using their own separate blockchain. Examples include Bitcoin, Ethereum and XRP. Others use Tokens, which operate on top of an already existing blockchain that facilitates the creation of decentralized applications. Some tokens are Dai, Maker, Ox, Auger, Komodo and Golem. Although the newness, the variety and the structure of cryptocurrency can be confusing, it's not a fad or flash in the pan. The market capitalization (or total dollar value of a company's outstanding shares) of the top three digital currencies are in the billion-dollar range.

Here's another way of looking at it: if you invested $1,000 in Bitcoin in 2011, it would be worth over $60 million today.

How is cryptocurrency taxed?

The first guidance regarding federal taxation of cryptocurrency, issued by the IRC, came in the form of IRS Notice 2014-21. The main takeaway of the Notice is that cryptocurrency is not considered currency, but rather property, and is taxed as such.

The value of cryptocurrency is reportable as the fair market value in terms of US dollars on the date of payment or receipt. Any gain or loss is reportable, and the character of the gain or loss depends upon whether the cryptocurrency was exchanged for a capital asset, such as stocks, bonds or other investment property. Because cryptocurrency is considered property, the Section 1091 wash sale rules don't apply since they're only applicable to stocks and securities. This isn't tax advice; you should always consult with a tax professional for guidance on cryptocurrency taxation specific to your tax situation.

The table below illustrates how taxes may impact a party depending upon how they're interacting or using cryptocurrency.

Is Foreign Reporting Required?

Cryptocurrency is currently not subject to FBAR (Foreign Bank and Financial Accounts Form), but that's likely to change per Notice 2020-2. FinCEN (Financial Crimes Enforcement Network) indicated its intentions to amend the foreign reporting rules to include virtual currency as a type of reportable account.

FATCA (Foreign Account Tax Compliance Act) or Form 8938 is also not required. But if you already meet the thresholds, it's a good idea to report using the Form.

On the 2020 Form 1040, the IRS included the following question:

"At any time during 2020, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?"

The Form didn't refer to or use that information, and there is likely more regulation and guidance regarding cryptocurrency from the IRS coming in the future.

Some Final Things to Consider

The IRS did release additional frequently asked questions in 2019, which elaborated on the original Notice 2014-21. Some additional cryptocurrency events were clarified including:

While cryptocurrency may still feel new, and has many risks, it's here to stay. How it will continue in the long term and how governments will ultimately regulate, adopt or compete with it remains to be seen.