Tax preparers may by now have encountered clients' transactions involving bitcoin, ethereum, and other virtual currencies. What they might just be beginning to see are clients day-trading these currencies. Recent price swings have attracted interest among retail investors—and definitely the IRS's. In fact, the IRS has sued one of the largest third-party exchanges, Coinbase, for customer information to find underreported income (Coinbase, No. 17-cv-01431-JSC (N.D. Cal. 11/17/16) (ex parte petition filed)). Despite its enforcement measures in this area, the IRS has not provided comprehensive guidance for tax reporting of virtual currency trading. It did provide some general guidance in April 2014 in Notice 2014-21 (see also "Tax Practice Corner: What Tax Preparers Need to Know About Digital Currency, JofA, June 2014, and "Technology Q&A: Digital Money: A Bit About Bitcoin," JofA, March 2016).
According to the notice, stocks and virtual currencies are taxed the same when held as capital assets by the taxpayer. Virtual currencies are characterized as property rather than as currency for tax purposes. The IRS considers a virtual currency not to be a real currency, even though it acts like one. For example, bitcoin is a storer of value, a unit of account, and a medium of exchange, but it has no physical form and is not legal tender in any jurisdiction.
More importantly, the IRS is interested in virtual currencies that are convertible. Some virtual currencies can be traded only inside a closed world, such as tokens inside the game of Pokémon Go. Other virtual currencies, like bitcoin and ethereum, can also be traded in an open world, such as on a third-party exchange like Coinbase and its platform for speculative trading, GDAX, and can be transformed into real currencies, services, or goods.
There can be tax consequences for the trader in convertible virtual currencies. For example, a sale of bitcoin for dollars creates a tax event and a possible tax liability. Taxable gains or losses for virtual currencies are determined, in part, by using the exchange rate quoted on the third-party exchange, given that the rate is determined by market demand and supply.
CALCULATING TAXABLE INCOME
For the tax preparer, determining taxable gain or loss for clients trading virtual currencies is similar to that for stocks. As stated by the IRS, there will be gains or losses when the fair market value of the virtual currency sold is greater or less than its adjusted basis. While stock trading occurs in a brokerage account, virtual currencies trade within "wallets," which reside either with the third-party exchange or on the trader's electronic device.
Example 1: On June 17, 2017, one bitcoin is purchased for $2,664, and it is sold on Aug. 6, 2017, for $3,322. The gain of $658 ($3,322 — $2,664) is short-term capital gain.
Rather than converting virtual currency into dollars, their holders can exchange them for other virtual currencies, which is not possible for stocks. Per the IRS notice, the taxpayer can recognize a gain or loss when virtual currency is exchanged for another virtual currency. This means the trader could owe a tax liability but have no real currency to pay it with.
Example 2: Assume the same facts as Example 1, except the one bitcoin is exchanged for ethereum. Also assume the bitcoin—ethereum exchange rate is 1 bitcoin (BTC) = 12.3214 ethereum (ETH) and that the ETH—dollar exchange rate is 1 ETH = $268.49. The trader has a dollar value of $3,308 in ethereum and a taxable gain of $644 ($3,308 — $2,664).
Taxable gains from exchanges of virtual currencies could be delayed if the like-kind exchange rules under Sec. 1031(a)(1) apply. They do not apply to stocks (Sec. 1031(a)(2)), but it remains unclear whether they might apply to virtual currencies. The AICPA has requested that the IRS clarify "if there are particular factors that distinguish one virtual currency as like-kind to another virtual currency for section 1031 purposes" (AICPA Comments on Notice 2014-21, June 10, 2016).
TAX REPORTING AND ACCOUNTING
Beginning in 2011, third-party reporting of cost basis from certain securities began under Sec. 6045(g). However, unlike stocks, virtual currencies are not "specified securities" and thus lack tax guidance that would ease tax accounting and reporting of basis in trades. Without third-party reporting, it falls upon tax return preparers to summarize and report their clients' virtual currency transactions. (However, Notice 2014-21 notes that a Form 1099-K, Payment Card and Third Party Network Transactions, may be issued for payments made in settlement of reportable payment transactions, including those made by virtual currency.)
Under the cost-basis rules, stock traders can use the default method of first in, first out to match purchases and sales of stocks (Regs. Sec. 1.1012-1(c)). In addition, taxpayers may elect other methods of tracing basis of stock shares to find the most tax-efficient accounting method (Regs. Sec. 1.1012-1(e)(2)(i)). Unfortunately, none of the alternative methods is available for bitcoin or ethereum, since virtual currencies are not characterized as stock. Thus, return preparers must be aware of the accounting method used by third-party exchanges when they report virtual currency transactions to customers.
With bitcoin futures, however, virtual currencies will soon be more similar to stocks. By the end of 2017, the Chicago Board Options Exchange reportedly will launch bitcoin futures. Trading bitcoin futures, rather than actual bitcoins, could eliminate the unfavorable tax consequences associated with trading virtual currencies. Under certain circumstances, futures taxed as Sec. 1256 contracts receive a favorable tax treatment, where 60% of the gain is taxed as long-term capital gain and the remainder is taxed as short-term capital gain (Sec. 1256(a)(3)).
Due to their novelty, bitcoin futures' tax characterization is uncertain at this point. But if taxed as Sec. 1256 contracts, then bitcoin futures would also simplify tax reporting for traders. Sec. 1256 contracts are subject to a mark-to-market regime, where open contracts are marked to their market price at the end of the year (Sec. 1256(a)(1)). The profits and losses from these open contracts, along with the closed or completed contracts, are reported on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions (Regs. Sec. 1.6045-1(c)(5)(i)).
Due to recent price highs and swings, tax preparers may have clients who are trading virtual currencies and for whom preparers should consider the following for the upcoming tax season:
- Ask on the year-end tax organizer whether there were any virtual currency transactions, especially trading.
- Report virtual currency trades on Form 8949, Sales and Other Dispositions of Capital Assets.
- Confirm the accounting method used by third-party exchanges for reporting virtual currency transactions.
- Discuss with clients who trade virtual currencies the limitations of deducting short-term capital losses.
- Discuss with clients the potential tax benefits of trading bitcoin futures.
Tom Prieto (firstname.lastname@example.org) is an author, a CPE instructor, and an accounting professor at College of the Canyons in Santa Clarita, Calif.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.