Cryptocurrencies: A Hot Tax Topic and Alternative Investment

Everyone has heard about Bitcoin, but there are more than 5,300 cryptocurrencies to choose from if you are thinking of investing in this relatively new — and hot — investment space. There is lots of talk about these decentralized currencies, and many of us know people who have gotten in and made a lot of money or lost most of their investment. And while these investments are not for everyone, big players like Amazon, Target and Tesla are taking positions and doing business transactions with crypto.

Tax Issues and Cautions

There are tax issues associated with crypto investments. As far as the IRS is concerned, cryptocurrency is a capital asset just like a stock or a commodity. If you buy a cryptocurrency for $100, hold it, and then sell it or buy something with it, you have a taxable capital gain or loss. As example, say you buy a hypothetical CCCcoin for $100 and see a nice pair of shoes that are selling for $140, or 1CCCoin. So you transfer the coin to the store and they give you the shoes; you then have a short- or long-term capital gain of $40 to report. If you hold that coin for more than one year you have a long-term gain; if you hold it for less than a year it is considered a short-term gain. Either way, it must be reported on Schedule D as part of your year-end return.

At present there is no IRS documentation required for tax purposes, as a bank or stock brokerage provides, so you are on your own for reporting purposes. But do not think for a minute that the IRS doesn’t know what is going on; they have a specific group of investigators who track cryptocurrency transactions. The reason the coins work is because the issuer “issues” keys to identify and lock the cryptocurrency for security and reliability. The IRS is looking hard at the “Dark Web” for illegal transactions and is always on the hunt for unreported income. So if and when you invest in cryptocurrency, keep good records!

Another mistake investors make is trading one cryptocurrency for another. For example, if you take your 1CCCoin and trade it for 2DDDCoins you must report the disposition of your CCCoin. There are no tax-free exchanges. Think of the early days of mutual funds, when many people thought that if they bought one mutual fund in a family of funds such as Vanguard, they could trade it for another in the family without any tax repercussion. However, since each fund has its own price, the gain or loss is reportable.  It’s the same premise with cryptocurrencies.

Capital Gains and 24/7 Trading

Capital gains are tax advantaged today because if you hold them for over a year you benefit from a lower capital gains tax rate — as little as 0% and as high as 23.8%, which is better than ordinary income rates. If you have losses, however, these can create a tax disadvantage. While they can offset short- or long-term capital gains, if you have excess losses the deduction is limited to $3,000 per year until you can offset them against gains. A big swing down in value and a sale for a large loss may mean the benefit of the loss could take years to realize.

When you invest in the stock market it opens every weekday morning and closes later that day. The market is closed on weekends and holidays. This isn’t true for cryptocurrencies, as the market is worldwide and open 24/7 year-round. Cryptocurrencies are very volatile. Just look at Bitcoin, the largest currency by volume and market cap: it had a low last December of $23,464 and hit a high of $63,822 on April 15. A little more than a month later, on May 24, Bitcoin closed at $38,706. Go figure.

Is Crypto for You?

If you believe that the entire world will eventually embrace cryptocurrency, then having a position in one or several coins that you have researched as reliable may be appropriate. Think of it as akin to investing in gold or silver, which have been held as hedges against inflation, war, or recession for most of recorded history. A cryptocurrency should react the same way. I often tell clients that gold is a rock with little useful value but a lot of intrinsic worth. Cryptocurrency is not even a rock, but it can be reliable to the extent the public will accept it.

Cryptocurrencies are popular because they make global trading and transactions easier and legally skirt established financial systems. And like gold, they have a value in every country and enable people to do business all over the world.

These coins are undoubtedly here to stay, so we should educate ourselves about their potential and pitfalls and evaluate individually whether they should be a part of a balanced portfolio. If you have questions about the tax consequences of holding or trading in cryptocurrencies, please contact our tax team at Hood & Strong LLP.

By George Paulsen, Tax and Advisory Partner