If there was any doubt about the interest the Internal Revenue Service takes in your cryptocurrency income, the agency sent a clear message last fall: You must pay tax on those earnings.
The admonition came last November in the form of what is called a John Doe summons to Coinbase to give the IRS the information the San Francisco-based cryptocurrency wallet and exchange had on all of its users for three years, including everything from a user’s confirmed devices to every line of correspondence between Coinbase and its users, which at the moment, total 6.4 million. (Don’t panic — Coinbase hasn’t handed over any data yet.)
“That’s a warning sign to taxpayers that they need to stop underreporting their bitcoin income, because it will become a point of enforcement by the IRS in the future,” says Tyson Cross, tax attorney and founder of Cross Law Group and BitcoinTaxSolutions.com.
While the specifics of the Coinbase/IRS case get worked out, you should, in the meantime, get your records in order if you’re a user or holder of bitcoin and other cryptocurrencies such as ether (used in Ethereum), Litecoin, Monero, Zcash, and any other protocol token or app-coin such as Golem, REP tokens, SiaCoin, Filecoin, etc.
Besides, there’s a positive reason you’ll need those records, says Jake Benson, founder and chief executive officer of Libra Tax, which offers software that tracks your cryptocurrency transactions for tax purposes: “This year, there’s more gains to be realized than any years in the past, considering the [bitcoin] price is high.”
Keep A Ledger Of All Transactions
(The header of this section is an inside joke if you understand how the technology behind cryptocurrencies work. If you don’t, I’m half-kidding — it doesn’t have be one ledger.)
While filing your tax return is typically a time for a little financial spring cleaning of your records, crypto asset holders should approach this task a bit differently for two reasons.
First, the industry is nascent enough that the IRS could, in the future, issue retroactive rulings. After all, messy situations like the DAO, the Ethereum/Ethereum Classic split and the Bitfinex hack aren’t even a year old, so the IRS may someday clear up what to do in situations like that. (If you’re not familiar with any of those cryptocurrency fiascos, read below.)
Second, the relative immaturity of the industry means that the exchanges or other services you use may not hold onto the records of your transactions as long as, say, Chase or Vanguard might. For instance, OKCoin only gives its customers records for the three most recent months.
That’s why instead of spring cleaning, you should make sure your records contain every transaction from the earliest to the most recent — like the ledger used in bitcoin and other blockchain-based assets.
“If the IRS were ever to audit your tax return, the burden is on you, the taxpayer, to prove you entered it correctly. And that will come down to what documents you have,” says Cross.
What Details To Record
Your transaction history doesn’t have to be fancy. Similar to the way you might log miles you drove for work, you could keep a contemporaneous log with the date and any relevant details — broadly, the date, how many bitcoin you gave up or received, the price at that moment, the price of whatever goods and services you were buying or received (including other cryptocurrencies), and a description of what you bought and where.
For instance, if you mined some bitcoin, “at the time of receipt, that’s ordinary income that needs to be reported on your tax return, and the value of the coin on that day is your cost-basis going forward,” says Cross. That’s the number that you’ll use later on, when you sell or spend that coin, to calculate your capital gains. If you don’t want the hassle of paying taxes twice, then convert out of bitcoin on the day you earn it — though then you also don’t enjoy any gains that the cryptocurrency might enjoy in the meanwhile. (This article goes into more detail on what data is needed to pay taxes for each of the ways in which one might obtain or dispose of bitcoin and other cryptocurrencies.)
If you only ever transact in cryptocurrency with one of the regulated exchanges like Coinbase or Gemini, you can easily download a transaction record — Coinbase, in fact, enables a variety of reports including one called Cost Basis for Taxes (in beta). But for other exchanges, check to see what details their reports have and how far back reports are accessible. Be sure to always download records before they become inaccessible.
In addition to the logs themselves, you should also keep documentary records. For example: “Receipts if you purchased something,” says Cross. “If you’re mining coins, the statement from the mining pool. If you’re talking about getting paid bitcoins for work you did, then the documentary evidence would be the invoice you sent to the payor.”
If you trade one cryptocurrency for another — say, bitcoin for ether — some people assert that you don’t need to recognize gain on that transaction and instead, it qualifies as a like-kind exchange. However, like-kind exchanges need to be reported on your tax return even if you don’t pay taxes on them, so be conservative and track those transactions as well.
Finally, if you’ve lost more than $3,000 in cryptocurrency — a distinct possibility for big bitcoin investors back in 2013/2014 when the price peaked and then steadily declined until 2015 — you will have capital losses that you can carry forward since you can only deduct $3,000 per year. For instance, if you lost $100,000, you could carry those losses forward for 33 years.
It might seem like a lot to track, but, Cross points out, these documents are typically paperless, so there’s not much to be gained anyway by spring cleaning these records. “What do you gain by deleting a spreadsheet?” he says.
Uncertain Area 1: The DAO
As mentioned above, the place where cryptocurrencies and taxes meet is a relatively uncharted one, and this is no better demonstrated than in three major incidents in the space in 2016.
Even if you weren’t affected by these incidents, understanding them could be helpful if you are ever in this situation in the future. Here’s a brief summary of the first two, which are related: The DAO was an Ethereum smart contract-based, crowdfunded venture fund that raised $150 million. However, a loophole in the code enabled $50 million worth of investors’ funds to be siphoned off. The Ethereum community attempted to undo the heist in the DAO by “forking” the code to create a new chain that consisted of transactions up to the DAO, but a small community who disagreed with this solution bought and traded the tokens on the original chain and dubbed themselves Ethereum Classic. That coin, Ether Classic (ETC), now trades at a fraction of the majority-supported Ether. So, when it comes to how to tax this situation, as Cross puts it, “The DAO is a messy one.”
One way to look at it is that DAO token holders exchanged Ether to acquire DAO tokens, which is a taxable event. They should then pay taxes on any gains they had on the Ether they gave up. But then they had a loss on the DAO tokens that were hacked, so they could claim a casualty loss. However, because those were restored by the fork, then the loss sort of didn’t occur. “What I’ve seen is most people are essentially ignoring the DAO fiasco,” says Cross.
Others are going with the interpretation that the DAO tokens were property lost and the new Ether was a reimbursement. In that case, you would use the value of the DAO tokens you lost as the cost-basis for your new Ether. Cross said how people choose to treat it often depends on how much money they had in the DAO and if there’s a tax benefit one way or another.
Uncertain Area 2: Ethereum/Ethereum Classic
If that wasn’t enough to wrap your head around, the even trickier situation is how to handle the Ethereum fork. Immediately before the fork, Alice has X Ether. Immediately after, she has 2X — X of Ether and X of Ether Classic. While it might seem similar to mining Ethereum, Cross point out that ETC didn’t have a market value immediately after the fork. It was only four days after the fork that any exchange even listed ETC. That means that if you decide to report your ETC as income, “you can decide to lean more in your own favor and take a low valuation,” says Cross, “but be prepared that if you were ever audited, the IRS might disagree with how you valued that ETC.”
Bottom line: it’s best if you get some professional help with this one. “This is one of those edge cases where you and your CPA figure out what you think is reasonable and you file in a way that you believe satisfies the requirements that do exist,”says Benson. “There is no rule of thumb or guides on how to deal with something like that.”
Uncertain Area 3: The Bitfinex Hack
In August 2016, Hong Kong-based Bitfinex suffered the second-largest hack of a cryptocurrency exchange and, to keep itself from shutting down, socialized the losses among all users and issued tokens so users could be repaid in the future once the company recouped the losses (which actually happened last week, eight months after the hack).
If you were a Bitfinex user in August 2016, you could deduct a “theft loss” on your 2016 tax return (which presumes the hack qualifies as a theft according to Hong Kong law), but that means you can only deduct the amount you paid for the stolen coins — not their value when they were hacked. But the amount of the deduction would be reduced by any reimbursement you received. Bitfinex did issue its users BFX tokens that had a face value of $1 based on the fair market value of your stolen coins, but it’s not clear if those constituted full reimbursement or a right to reimbursement in the future.
If your accountant interpreted that as full reimbursement (less likely than the next scenario outlined), then you wouldn’t take the theft loss deduction in 2016 — but you would pay capital gains on the difference between the value of the tokens and the price you paid for them.
It’s more likely your accountant interpreted the tokens as a right to future reimbursement. In that case, you wouldn’t have to reduce your theft loss deduction unless you sold, redeemed or converted your BFX tokens in 2016. (And then the amount you’d lower the deduction by is the amount you received in return.)
If you didn’t take any action with your tokens in 2016 but fully redeemed them in April 2017, then you have to recognize that income on your 2017 return, which would offset the benefit you received from the theft loss deduction in 2016. And you’ll also pay capital gains on the difference between the value of those tokens and the amount you paid for them.
Phew! Got that? TL;DR: If you’re participating in the cryptocurrency universe, it’s best to keep as comprehensive records as you can until regulators someday catch up to the innovative but messy new developments in crypto assets happening every day.