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March 21st, 2022
This tax season, you may find that clients have a lot of questions on cryptocurrency and how to treat virtual income on their tax return. If your client answered “yes” to the question on the Form 1040 about virtual currency, today’s blog post is for you. We’re diving into some different virtual currency scenarios to determine how best to handle them — what makes someone an investor? What about a miner? What does it mean to make a purchase with a virtual currency? We also spend time talking through helpful tools available and virtual currency terms like blockchain, hard fork, and soft fork.
By Tom O’Saben, EA
Assistant Director, Professional Development & Outreach
U. of I. Tax School
LINK REFERENCED IN VIDEO:
Hello again, everybody, Tom O’Saben coming to you from the University of Illinois Tax School. You’ve got about four weeks left for tax season. So one of the topics we’ve been running into during the filing season is cryptocurrency issues. So we’re going to approach this discussion this week, from the standpoint of you sitting across the desk from a client. And you ask the question, did you have any activities in virtual currencies? And the client answers “yes, yes, I did”. Now the next question becomes, what do I do now? Here’s my information for those of you who have not heard me before. And we’ll also have a link at the end of this presentation to my bio in more depth with the U. of I. Tax School.
So here’s what I’m describing right on the front of the 1040 for 2021 is in fact, what I’ve circled, where again, at any time during 2021, did you receive, sell, exchange or otherwise dispose of any financial interest in any virtual currency. You’re gonna see, what I describe as going in as I go through here is that when you get with into the terms of receive and exchange, think about those as synonymously. Think of those excuse me, think of those synonymously. When we talk about receive, we’re not talking about purchase, we’re talking about receiving it in return for something else, stay with us, I’ll explain what I mean.
So from an overview standpoint, the IRS out of notice 2014-16 made the conclusion that all cryptocurrencies are capital assets, just like any other capital asset, and a tax event is going to happen when they’re sold or, sold is not even a good term here. When they are used, I’m going to say it that way. Just like when a client sells or exchanges traditional investments, like stocks or bonds, or mutual funds, an event occurs. Remember, in the mutual fund world that can happen even within a familyt, can’t it? So unless we’re dealing inside of a qualified plan, the movement of that cryptocurrency, virtual currency, cyber currency, whatever you want to call it, into something else is going to cue a capital transaction. What we see here and the second point says, Is it long term or short term? Tell me how long your client has held it? And I’ll tell you whether or not it’s going to be short term, which would be ordinary income, or is it long term because it was held a year in a day and would receive those preferential capital gain rates. Could be as low as zero couldn’t they are as high as 20%.
We’ve got a nice FAQ that the IRS provides, you can see it in our third bullet point. At the IRS website, I think that’s a good place to go to get some of your questions answered in more detail.
So we need to determine whether or not our client is an investor or are they in the active conduct of trader business. So we say that buying a virtual currency creates the basis and begins the holding period. So my first question becomes, alright, what do you mean by basis? We’re going to have to have a common denominator and a common denominator throughout this entire presentation is going to be we are going to need to use the US dollar. That’s going to be our common denominator in everything that we talk about in the arena of cryptocurrency. Now, going back to the question on the front of the 1040. The term receive as I started to explain, on the form 1040 implies an exchange, not just an original purchase. Here’s a quote actually from the IRS. It says while buying and holding crypto doesn’t require a Yes, stop right there. Buying and holding crypto doesn’t require you to answer that question, “yes”. Okay? We need to check that box if our taxpayers sold, exchanged, mined digital assets or use them for purchases. So think about that term, used it for purchases? Did we receive something for that bitcoin, ethereum, whatever cryptocurrency it might be? That’s the point to consider. I think a lot of our clients are going to fall under this buying and holding, which would imply they are investors, correct? And in that environment, we can answer the question. No, they are in fact, an investor, but they haven’t traded their investment.
How about making purchases with virtual currencies? If we’re going to purchase goods or services, we’re going to have a sale of that virtual currency. And we’re going to have to use that U.S. dollar as the common denominator. That’s going to determine two things happening here. One, do we have a gain or loss in the sale of that cryptocurrency to turn it into a car repair? You know, we used it at a car repair place, we paid in Bitcoin, we got a car repair in return. One, how much gain or loss did we have in the conversion of that Bitcoin to US dollar gain or loss? Is it going to be long term or short term? Depends on the holding period. The second thing is, we’re going to have to determine then our basis in the purchase, which is going to be basically that same amount that we used as the gross proceeds for the value of that virtual currency in US dollars. Does that make sense? So we’re going to have always two circumstances coming out of the use of a crypto or virtual currency for purchases. One determining the gain or loss on that conversion of that virtual currency into a good service or US dollar, that will also be our proceeds. And it will be our basis in what we acquired for that virtual currency.
Now, let’s talk about virtual currency miners. When someone creates a mining operation, I’ll explain that to you in a little bit, which is a blockchain. And that’s about as much as I know about it without getting into a whole bunch of algorithms, and machine language, which we won’t do. But when a taxpayer receives virtual currency through a mining operation, that receipt of virtual currency is ordinary income. This guidance is from the IRS. We have ordinary income from mining activity. We also then have capital gain or loss, there are two factors going on with with the miners. One is going to be what is that ordinary income? Common denominator, again, US dollar so that the amount that we’re going to have to deal with that’s going to be treated as income will be the fair market value of the mined coins that were received. That’s step one. But then later, when those mined coins are exchanged for goods, services, or US dollars, or other types of virtual currencies, that transaction will in fact, be a capital gain or loss. So two steps. Now, when we talk about that amount, that’s going to be the ordinary income -that will also give us our beginning basis for later sale and capital gain treatment.
The question that then has to be asked is for those currency miners – are they in fact, engaged in the activity as a trader business? Do they have a profit motive? Well, for those of you who know me, well, you know that I am a disciple of the nine questions under code section 183. Not one of those nine questions is more important than the other. And perhaps you should have an annual conversation with the client. After going through these nine questions, if you determine that the taxpayer is in fact engaged in this mining operation, as a trader business, then the fair market value of those mined coins, that’s going to represent your gross receipts on Schedule C. That’s going to be the gross income item. But what more can we do, then? We can go ahead and take reasonable and necessary business expenses under code section 162 against that fair market value of the mined coins received. And, when you do a Schedule C, you know that we could also possibly have a loss. So when I tell clients when they’re thinking about doing any kind of activity that’ll be engaged in for profit, they say, “well, what expenses should I keep track of?” I tell them keep track of anything that you spend money on that if it weren’t for this business activity, you wouldn’t be spending it. So let’s think about what could be some reasonable expenses under 162 for this minor. Well, how about internet access? How about the computer? How about the printer? How about the desk they’re sitting at? How about office use of home? How about office supplies? How about a potential for mileage? So anything again, that could be related to that trade or business that if it weren’t for that trade or business, they in fact, would not be involved in that activity? And again, could we have a situation of showing a loss? Now, if running through these nine factors, like I said, this is no different than any activity that your client would be involved in that you’re considering whether or not they’re in the active conduct of a trade or business. If we determine that it’s a hobby, well, we still have income – where’s it going to go? 1040 Schedule One. So it’s going to be hobby income. What’s that hobby income? The fair market value in US dollars of the mined coins received. But since it’s a hobby activity during the tcja years of 2018 through 2025, we’re not going to have any expenses that we can take against that hobby income. I know that I have taught in previous sessions about the notion of being able to take a reasonably and consistently allocated cost of sales. I don’t really find anything in a cost of sales when it we’re dealing with virtual currency miners, I think what we would have would be indirect costs, which under a hobby environment would not be deductible, we’re going to have hobby income, but no expenses. So, are we going to have the active conduct of trader business, ask the nine questions, that’s going to be determined where you report the coins that were mined in US dollars. If we determine a trade or business Schedule C. If it’s not Schedule C, then 1040, Schedule One. So here, if we if we determined that the activity is in fact not engaged in for profit, and it’s a hobby, we’re going to put that on schedule one, line one line Z. Like the last line that’s available for that.
So I wanted to do kind of a flowchart here of what an individual will have who is a miner in the taxability of their transactions in the cyber currency world. So let’s take a look at this and flow along together. So if we determine that we have a mining operation, or there is a mining operation, the receipt of the coins, step one, ordinary income for the virtual currency received in what? US dollars. That’s going to give us our ordinary income. Then the next flow is to go to the nine factors. Okay? If we determine that activity is engaged in for profit, then we can have 162 reasonable and necessary business expenses, which that is going to give us a profit or loss. If we have a profit, then we could in fact, have C tax, couldn’t we? So we’ve got this whole flowchart here. That tells us where we’re going where we’re going to go. Now, that’s step one. Step two, so we could say this is this is step one. Now, later on, when that taxpayer sells those mined coins, they do not go on schedule C. The guidance we have says they are again, as the IRS said, they are capital assets. So being capital assets, we’re going to have capital gain, or capital loss, and that reporting is going to be done on 8989 49. So two ways to approach the miners activities.
Let’s have a conclusion about someone who’s an investor. They are buying and holding. If we are buying and holding, then the taxpayer can honestly answer no to that 1040 question on the front of the return. The time they purchase it, that’s going to begin the holding period. And the buying and holding is also going to equal capital gain or loss when sold or exchange later. And remember sold or exchange could be going to just US dollars, could be going to other types of virtual currency. Or it could be for goods or services, couldn’t it? So think about that received or exchanged for something else will will indicate what’s happening. But going back all the way to the beginning for our investors, just buying and holding does create the circumstance that the question on the tax return can be answered honestly as “no.” Forms that would be involved in your tax return could in fact include 8949 That would be the exchange of those cryptocurrencies for other forms of value, which will flow to Schedule D. You’ve got Schedule C for those minors who have an active conduct of trade or business for their activity. And then finally, 1040, schedule one as we described earlier, in those circumstances where after going through the nine factors, we have concluded that the activity does not rise to the level of a trade or business.
While we’re on this page, I’d like to talk about what my software does. It’s kind of interesting. When you answer the question, yes, you’re brought to another screen to report the transaction. And the software will ask what type of transaction is it? Is it a an investor activity, or is it a mining activity? If it’s a mining activity, the software is going to take that transaction to Schedule C. If it is an investor actually activity, it’s going to take the disposition of that cryptocurrency to 8949. And it also does have a question on there about hobby. If it’s hobby, it’s going to take it directly to 1040, Schedule One. You might have this in your software as well. When you’ve got some quiet moments to maybe play around with a transaction, answer that question yes, and see what drop down your software might provide you.
Also came up with some tools that could be useful during this time of year. If you’re looking for some ways to calculate the basis in the coins that your client has, there is a website called Koinly. I’m not necessarily supporting these, it’s just a place for you to look at. There’s also Coin Tracker. And I also found a site called Coin Market Cap, which has some historical values for cyber currencies as well. This may help you in in helping your client determine their gain or loss when they exchanged or moved their virtual currency into something else.
There’s virtual currency terms that we need to be aware of. People will talk about a wallet. In my simple world, a wallet is just like a brokerage account. And you might have a brokerage account at Morgan Stanley with a client and the client decides to go ahead and move that to Edward Jones, for example, well, that’s what a wallet is it contains the coin just like a brokerage account contains the investment securities that might have been moved. What you want to be aware of is if your client actually changes wallets, the basis in that original purchase may not be picked up by the new firm. We have that same problem when people change brokerage firms, maybe they’re just following the broker they like dealing with. And the basis was all done to the purchases were all done at the former firm, it’s going to be important that that new firm have that original cost basis in those investments. No different in the virtual currency world, we have the circumstance where the wallet or the basis the new wallet, they may need to get that information from the original wallet.
Blockchain. I’m going to describe this as the virtual version of the New York Stock Exchange. The New York Stock Exchange was originally created as a place where persons could go to buy and sell securities and the creation of a a fixed market. In other words, the price was not going to be different from other places in the country. So a blockchain creates a network for persons to come online and buy and sell in a formed market. So we don’t have the wild wild west of “well, to me, it’s worth this to you it’s worth that.” So the blockchain creates that network of buyers and sellers in that coin.
Another term you’ll see is a Hard Fork. I described as kind of like a stock split, but not exactly I want you to concentrate on the term fork. Think of a fork in the road. So what’s happened is in a hard fork, a coin is split off into some other type of virtual currency. But it creates another marketplace. So it we say here it is incompatible with the existing blockchain. Think about the New York Stock Exchange. And then what used to be I’m really dating myself on this folks, but the American Stock Exchange, another place to trade transactions, but the two are not compatible. It’s creating another route for buyers and sellers to operate when a coin is split into another coin, but we could also have a soft fork in the road, where there is a new version of that virtual currency created. But it’s tradable within the same network, the same blockchain. It is compatible with that original blockchain to invite in perhaps, more buyers and sellers. Perhaps it’s done where the price for that coin would be lower than perhaps where bitcoin is trading at the time. So some terms to understand, just from enough knowledge that we know what they’re talking about. Because ultimately, what are we trying to do? I could see myself tapping my pencil on the table saying, we got to determine “did you make any money?” That’s ultimately what we’re after, isn’t it?
Some other thoughts as we wrap up this session. Can individuals buy virtual currency in an IRA? The answer is yes. There’s all kinds of IRAs out there now that will hold cryptocurrency, trade cryptocurrency. And there’s also different kinds of IRAs that can be used, but I think it still answers the question “no,” back to the original 1040. Did you receive or exchange virtual currency assets? I think if it’s not something that would end up on a 1040 I think the the question again is, no. But what’s going to happen here in this virtual currency IRA, eventually a taxpayer is going to make withdrawals. And those withdrawals are going to be in US dollars. And those US Dollars unless they have non deductible contributions in that IRA, those distributions are going to be 100% taxable, aren’t they? Other thoughts you might have when you’re working with somebody right now, and perhaps they are a miner, you’ve gone through the nine factors and determined the activity is engaged in for profit? Could they go ahead and fund a retirement plan? Since they have net profit? Absolutely. Could we be sitting there on April 10, have a $10,000 profit in mining, after we’ve taken our reasonable necessary business expenses? Could that taxpayer fund a SEP? Sure they could. So again, what’s your support? The nine factors that you discuss with the client? Could we offset currency gains on the 8949 and Schedule D, with losses and other capital type investments? Answer Yes. But unfortunately, the taxpayer would have had to get rid of let’s say the investment losers before the end of the year. Otherwise, what we’re doing now is we’re planning for next year.
So lots to think about in all of this area of cyber currency, what I hope the main takeaway would be, especially in the notion that most of our clients are going to be dealing with three things in cyber currency. One, we’re going to have to use a common denominator, which is the US dollar. That is going to give our basis for everything. Two, we’re going to have multiple transactions for a client, we’re going to have the conversion of that currency to a US dollar so that a US dollar can go and purchase a good service or just US dollars. That first step is going to create a gain or loss capital in nature, gain or loss. And then we look at the basis of what we receive, again in US dollars, as a starting point going forward. And then thirdly, for that individual who’s doing mining, the coins they receive for doing mining, are ordinary income. That ordinary income gives us the basis in the coin for the later determination of capital gain or loss. If we determined that the receipt of those coins and that mining operation rise to the level of an active conduct the trader business, then we’ve got Schedule C and commensurate reasonable necessary business expenses, net profit, SE tax opportunity to fund retirement plan. If the mining operation is determined to be a hobby, then we’re talking about 1040 schedule one.
I hope this information is helpful for you to get you through the waning weeks of the tax season. We’re here for you. Come and join our Facebook Group or check the Facebook Group or post a question there. Great group of people to have with you. And remember that all of us here at the University of Illinois Tax School are here for you. So this is Tom O’Saben, from the University of Illinois Tax School, saying goodbye for just a while.
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