The Taxation of Cryptocurrency
The mainstream emergence of cryptocurrency has outpaced public understanding of the latter’s tax implications. The IRS treats cryptocurrency like property (like stocks or gold) rather than fiat currency, a distinction that makes a difference when it comes to taxation. By understanding how the IRS evaluates the tax consequences of cryptocurrency, users can protect themselves from tax problems.
A cryptocurrency (“crypto”) is an electronic payment system that uses encryption techniques, rather than a central bank, to generate, exchange, and transfer units of currency. Participants record their digital transactions using blockchain technology. A blockchain is a public ledger or database that logs all transactions in a network. Blockchain makes possible a communal method for verifying transactions: modifications are confirmed from user to user directly, rather than involving banks and government authorities. This decentralization—this cutting-out of third-party intermediaries for the transaction verification—is crypto’s principal feature.
An unknown person or group of people introduced Bitcoin, the first cryptocurrency, in 2009. Five years later, in early 2014, the National Taxpayer Advocate urged the IRS to issue guidance as to how cryptocurrency should be treated for taxation purposes. In April 2014, the IRS responded with Notice 2014-21. This notice provided that cryptocurrency is property for federal tax purposes.
What does it mean to say that crypto is “property” instead of “currency”? To simplify: When you use cash to purchase something, you are not taxed for any gain or loss inherent in the cash you use to make that purchase. That is, changes in the value of the U.S. dollar are not considered taxable gains or losses. Not so for property, for which gains and losses are taxable (either as ordinary income or capital gain). For example, a person must generally pay capital gains taxes for selling a home at a higher value than that for which he or she bought it. The IRS’ stance is simply to treat crypto like property rather than like cash.
Primary takeaway: The IRS has recently increased enforcement of cryptocurrency taxation. Investors should work hard to understand crypto’s tax implications. Failure to pay taxes on crypto gains could result in substantial penalties and possibly jail time.
About the Author
Ashwat Giri is a third-year law student at Campbell University School of Law. He is an editor at the school's law review journal, president of the Business Law Association and he interned with Smith Dominguez, PLLC for six weeks in the summer of 2021.