The rollercoaster ride for some cryptocurrency investors could be about to take another tax-time lurch, according to experts, as the taxman looks for his share of transactions made using bitcoin and its like.
Wild fluctuations in the value of digital currencies – bitcoin surged from less than one dollar in 2010 to $997 at the start of the 2017 to nearly $20,000 before settling back to around $8,500 on Friday – have exposed investors to tax bills the value of their coins may no longer meet.
On Reddit earlier this week, one contributor, under the heading “I just discovered that I owe the IRS $50k that I don’t have, because I traded in cryptos. Am I fucked?”, wrote they had ended up with a $50,000 tax liability on trades after they sold $120,000 worth of bitcoin to buy different coins. The current value of those coins is about $30,000. “I feel like I might have accidentally ruined my life because I didn’t know about the taxes,” the poster wrote. One complication for crypto investors is that digital currencies that were, in part, devised to operate outside of government and banking industry oversight, are still of interest to the US tax authorities, who look at cryptocurrency as property and not currency.
According to the Internal Revenue Service, anything purchased using a digital currency is liable to be taxed as a capital gain. So anyone who has cashed out or paid for anything using cryptocurrency may have capital gains to report to the IRS.
Another source of confusion is that crypto-brokers are not required to issue 1099 disclosure forms – the forms used by the IRS to report income other than wages, bonuses and tips – on digital currencies, but individuals are still responsible for reporting gains.
In November, a US district court judge in California ordered Coinbase, a popular platform for trading bitcoin, to turn over identifying information on accounts worth at least $20,000 during 2013 to 2015.
Bitcoin is a 'cryptocurrency' – a decentralised tradeable digital asset. Invented in 2008, you store your bitcoins in a digital wallet, and transactions are stored in a public ledger known as the bitcoin blockchain, which prevents the digital currency being double-spent.
Cryptocurrencies can be used to send transactions between two parties via the use of private and public keys. These transfers can be done with minimal processing cost, allowing users to avoid the fees charged by traditional financial institutions - as well as the oversight and regulation that entails. The lack of any central authority oversight is one of the attractions.
This means it has attracted a range of backers, from libertarian monetarists who enjoy the idea of a currency with no inflation and no central bank, to drug dealers who like the fact that it is hard (but not impossible) to trace a bitcoin transaction back to a physical person.
The exchange rate has been volatile, with some deeming it a risky investment. In January 2021 the UK's Financial Conduct Authority warned consumers they should be prepared to lose all their money if they invest in schemes promising high returns from digital currencies such as bitcoin.
In practice it has been far more important for the dark economy than it has for most legitimate uses. In November 2021 it hit a record high of more than $68,000, as a growing number of investors backed it as an alternative to other assets during the Covid crisis.
Bitcoin has been criticised for the vast energy reserves and associated carbon footprint of the system. New bitcoins are created by “mining” coins, which is done by using computers to carry out complex calculations. The more bitcoins that have been "mined", the longer it takes to mine new coin, and the more electricity is used in the process.
The IRS case came about after the agency discovered that only about 800 taxpayers claimed bitcoin gains in each year from 2013 to 2015. But the Coinbase agreement only affects about 10,000 accounts, not the 480,000 accounts the IRS first requested.
Not reporting gains, it should be said, could amount to tax evasion.
And the capital gains ruling is not the only crypto-complication. If an investor sells a cryptocurrency after holding it longer than a year, then the profits are typically long-term capital gains. Nor are losses deductible against future tax years.
William Perez, a tax accountant at the online tax filing and advisory service Visor, has noticed that accountants are often unwilling to familiarize themselves with crypto-accounting rulings. “Among crypto-investors, I see resistance to reporting it,” he says. “Then there’s another group who’ve got a 1099 from Coinbase but they don’t know what it means.”
Investors are getting caught out in basic ways. For instance, crypto-to-crypto transactions are taxable – if, for example, you use your bitcoin to buy rival ethereum. “That often catches people off guard, but once you break it out you’ve sold one coin and invested in another. That’s one bear trap,” said Perez.
The second bear trap, Perez explains, is when crypto is used for purchasing. But crypto is not like PayPal or a gift card, and not merely a conduit of exchange. “Under accounting rules, you have property that you exchanged for something else.
“People think because they’ve paid a sales tax so that’s the end of the story. But it’s not. We’re talking about a property denominated in dollars. If you exchange that then there’s a tax liability.”
The IRS rules on crypto, Perez says, are straightforward. He anticipates the agency will leave the preliminary guidelines (issued in 2014) in place for a few years to see how they work out.
“The US government is getting some hands-on experience with how crypto works,” Perez says. The action against Coinbase, he points out, was about trying get visibility on trades and whose trading.
The way tax law is currently written, the government has no way to force crypto-brokers to issue trading information the way stock brokers are required to do.
“Once they get through the technological issues, they’re going to want to look at larger patterns, and they had to sue Coinbase because there’s nothing in law that requires crypto-brokers to do any information reporting. IRS wanted information so they could enforce tax law on individuals.”
Placing responsibility on the individual to report taxable income is, of course, in keeping with the libertarian perspective of crypto-world. “So on one side, yeah, it’s been easy to avoid tax, but on the other it’s part of the crypto ethos of personal responsibility to own up to it,” Perez says.
But shifting responsibility back from the individual back to institutions like Coinbase naturally presumes that information held by crypto-brokers is accurate to begin with.
Tax accountant Doug Sipe anticipates problems may arise when tax authorities attempt enforcement on scofflaw crypto-investors.
“Even they are getting notifications on transactions over $20,000 what does that actually mean? Do they have a social number? They may know of a transaction, and they may have a name, but can they enact any kind of enforcement? The question is what kind of information have investors given – besides an email address when they registered for an account?”
