Cryptocurrency and tax compliance: navigating the new world of digital money

Cryptocurrencies and tax compliance

As mid-April gets closer, the US taxpayers and their accountants are increasingly filling out forms to report their 2017 earnings and other financial details. The internet substantially changed how people file their taxes by allowing them to do it electronically. More recently, there’s something else that’s had a significant impact on filing taxes: cryptocurrency.

Indeed, digital currencies have tax compliance concerns associated with them. That means if a person owns any cryptocurrencies, he or she needs to know the tax specifics about them.

The same is true for accountants who assist cryptocurrency owners. Many have probably already dealt with clients who had questions about cryptocurrencies and tax returns. If they haven’t, they will soon.

The IRS treats cryptocurrency as property

A person who has never reported cryptocurrencies on tax forms before might automatically assume that the right thing to do is treat it as any other kind of currency, such as a dollar or a euro.

However, the IRS issued a document to clarify several things related to cryptocurrencies – and it mentions specifically that cryptocurrencies are properties for IRS purposes (click here to read the document on the IRS website).

In other words, they’re investments.

People paid in cryptocurrencies must report in US dollars

There is a growing trend among employers to pay workers portions of their wages in cryptocurrencies. Similarly, some people who are familiar with cryptocurrencies and believe in their potential may approach their employers and ask to receive part of their payments in digital currency.

In either of those cases, earners must convert the cryptocurrency amount to the fair market value equivalent in US dollars on the day of receipt. If the up-to-date value of a cryptocurrency is listed on an exchange, a person can use that information to calculate the earnings amount in dollars.

Reports of income from sales go on a Schedule D form

People involved with cryptocurrencies should carefully document everything when buying or selling them. If any sales result in gains compared to the purchase price, a taxpayer must record those as earnings on a Schedule D form. This is a supplement to Form 1040 – the standard income tax form for individuals.

However, the method of reporting the gain depends on the length of time a person owns a cryptocurrency. If the period of ownership before the sale is less than a year, it’s considered a short-term capital gain. The taxable rate is identical to ordinary forms of income.

However, a person who possessed cryptocurrency for over a year before selling it is then dealing with a long-term capital gain. That means the taxable rate is lower than for ordinary income and ranges from 15% to 23.8% based on a person’s tax bracket.

Do cryptocurrency miners have to pay taxes?

Some people are also confused about the tax obligations of cryptocurrency miners. For example, do they have to pay taxes on their profits? In most cases, the answer is “yes”.

A person who earns at least $400 in a year from cryptocurrency mining is subject to self-employment tax, whether that individual mines professionally or does so as a hobby. Also, if cryptocurrency mining has been profitable for a person for three of the last five years, including the current one, the IRS considers that miner to have a for-profit business.

The total earnings a miner makes could also necessitate paying estimated taxes every quarter. Failing to do so could result in owing a massive debt to the IRS with penalties tacked onto the unpaid tax amount.

Some aspects of cryptocurrency and tax compliance are fairly straightforward, particularly after people perform the required research or ask tax professionals who are in-the-know. However, that’s not true in all cases, such as those described below.

Cryptocurrency holders need not immediately report Income from chain-splits

A chain-split or “fork” occurs due to a permanent branching off within the blockchain. A cryptocurrency holder affected by this event ends up with the initial amount of digital currency held before the chain-split happened, plus an equivalent amount of the new currency that results after the fork.

One of the tax-related challenges related to chain-splits, according to accounting experts, is that taxpayers are not required to immediately report the earnings generated from them and may opt to never do it at all.

Taxable income becomes part of the equation when cryptocurrency holders opt to take action by exercising control and dominion over the coins derived from the fork. The worth of the coins for tax purposes depends on how valuable they are on the day an owner decides to take that step.

However, the IRS has not yet given guidance about this kind of transaction. That means everything is subject to change if a clear-cut decision gets publicised.

Auditors lack experience in with cryptocurrency transactions

Even when they fill out tax forms correctly and take the time required to check for errors to the best of their abilities, many taxpayers still wonder how likely it is that they’ll get audited.

Furthermore, some taxpayers who focus on investing also depend on the knowledge of people working for assurance services to assess their financial transactions and portfolios through internal audits.

There are only a handful of assurance practices experienced in auditing digital funds, which means investors may have difficulty locating assistance if they have questions about cryptocurrencies. Fortunately, if the popularity of cryptocurrencies continues, this issue will become less prevalent.

Early figures indicate most Americans are not reporting cryptocurrencies

People understandably have uncertainties about cryptocurrencies and taxes – especially about matters for which the IRS has not provided clear-cut answers.

One reason for this is the lack of a precedent. Individuals may assume that, since the IRS hasn’t handled matters similar to cryptocurrencies before, it’ll take a while before all the details get ironed out.

Also, a February 2018 report from Credit Karma indicated most of that site’s users were not mentioning cryptocurrencies on their tax forms. Of the 250,000 returns filed through the service so far in 2018, fewer than 100 mentioned a cryptocurrency transaction.

Interestingly, an earlier survey carried out by Credit Karma that polled 2,000 people revealed that nearly 57% said they’d had cryptocurrency gains.

Jagjit Chawla, the general manager of Credit Karma Tax, cited the popularity of cryptocurrencies in 2017 and noted, “we’d expect more people to be reporting”, but then clarified that people with complicated tax situations tend to file closer to the deadline, so it may be too early to tell the real story.

As cryptocurrencies continue to evolve, their tax implications will as well. That’s why it’s in the best interest of taxpayers and tax preparation professionals to stay abreast of developments and seek clarification, if it’s available, as needed.

By Kayla Matthews, tech journalist and writer
Read more posts on her blog, Productivity Bytes