As tax season heads into full swing, cryptocurrency traders may be in for a surprise when they sit down to complete their 2020 taxes. This year, for the first time, the Internal Revenue Service (IRS) is including a question about cryptocurrency transactions on the first page of Individual Income Tax Returns, Form 1040.
The question asks taxpayers if at any time during 2020 they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency (the IRS’s term for digital, convertible currency, such as Bitcoin, Dogecoin, and the like.)
The question, however, has caused some confusion among taxpayers, prompting the IRS to issue clarifying guidance. On March 2, 2021, the IRS updated its Frequently Asked Questions (FAQs) on Virtual Currency Transactions to clarify the new first-page question appearing on every 1040 this year. The IRS FAQ clarifies that taxpayers who purchased cryptocurrency with real currency and had no other cryptocurrency transactions in 2020 are not required to answer “yes” to the Form 1040 question.
This result makes sense given how the IRS treats cryptocurrency for federal income tax purposes. Under IRS interpretation dating back to 2014, cryptocurrency is treated as property, meaning individuals transacting in cryptocurrency must report and pay taxes on their gains (or may deduct losses) when selling or otherwise exchanging cryptocurrency for goods, services, money, or other monetary value. However, an individual who only purchases and holds cryptocurrency, without selling or exchanging the cryptocurrency, has not realized any gains (or losses) on the property under IRS rules. Tax liability is triggered upon a realization event, which would be the sale or exchange of the cryptocurrency for other property, services, money, or other monetary value. Thus, taxpayers who purchased cryptocurrency with real currency in 2020, but had no other cryptocurrency transaction that year, would not owe taxes on that activity.
The IRS FAQ, however, contradicts a plain reading of the Form 1040 question, which appears to broadly ask taxpayers about any transaction involving cryptocurrency, including merely receiving or acquiring cryptocurrency. While the IRS FAQ clarifies the more limited scope of the question, many cryptocurrency holders may still be confused.
For those with taxable gains or losses on cryptocurrency transactions in 2020, the IRS requires that you report those sales and calculate capital gain or loss in accordance with IRS forms and instructions, including on Form 8949, Sales and Other Dispositions of Capital Assets, and then summarize capital gains and deductible capital losses on Form 1040, Schedule D, Capital Gains and Losses.
As federal and state agencies continue to adapt their enforcement approach to virtual currencies, Venable will be keeping a close eye on developments. For any inquiries regarding the tax consequences and mandates not addressed here, please contact the authors for more information.
This article is provided for illustrative purposes only; it does not provide personalized tax, legal, financial, or other professional advice. Venable makes no recommendation regarding the appropriateness of any specific action. You should always consult a tax professional regarding your specific situation.