DeFi And Tax: How Are Digital Currencies Treated By The IRS? (Podcast) – Fin Tech
Cryptocurrency has gained in popularity. Many finance companies
have begun offering digital loyalty points and rewards. This sounds
appealing until it’s time to figure out how and when digital
currency may be taxed.
Aaron Kouhoupt: I’m Aaron Kouhoupt, a
member in McGlinchey’s Financial Institutions Compliance team
here in our Cleveland office. And I’m joined today by Doug
Charnas, a nationally recognized tax attorney and member in
McGlinchey’s Washington, DC office. Doug spent six years as an
attorney in the Office of the Chief Counsel to the IRS and has a
really good understanding, maybe better than most, on how the inner
workings of the tax code work. I’m pleased to have him here
today to talk to us about the implications of cryptocurrency and
digital currency in the tax world. Thank you for being with us
today, Doug.
Douglas Charnas: I’m delighted to join you,
Aaron.
Aaron Kouhoupt: So we’ve talked a lot
during our Deep Dive series about how digital and virtual
currencies and cryptocurrency differ from fiat currency. And as a
reminder for everybody, fiat currency is a government-backed
dollar, or government-backed coin, and we’ve really talked
about how that differs. Our question today is, how does that play
out in the tax space?
The most important thing to understand about digital
currency or cryptocurrency is that it is treated as property for
tax purposes. When you acquire cryptocurrency, your tax basis in
that cryptocurrency is the fair market value of the cryptocurrency
at the time that you acquire it.
Douglas Charnas: Aaron, the most important
thing to understand about digital currency or cryptocurrency (and I
tend to refer to it as cryptocurrency, so I’ll use that term)
is that it is treated as property for tax purposes. And what that
means is that when you acquire cryptocurrency, your tax basis in
that cryptocurrency is the fair market value of the cryptocurrency
at the time that you acquire it. And over time, the fair market
value of cryptocurrency as compared to fiat or U.S. currency is
going to vary. Whereas if you have a dollar, your tax basis in the
dollar is $1, and the value of that dollar is not going to vary
over time for tax purposes.
So let’s look at a couple of scenarios. Let’s assume
that you perform services; the value of those services is $1,000.
You receive $1,000 U.S. dollars; you have $1,000 of income. Instead
of receiving U.S. dollars, you receive $1,000 worth of
cryptocurrency. You also have $1,000 of income, but your tax basis
in that cryptocurrency is now $1,000. That’s not going to
change, but the value of that cryptocurrency is going to vary
against the U.S. dollar, whereas the amount of U.S. dollars that
you receive, the $1,000, that’s not going to vary. It’s
always going to be $1,000.
The mere purchase of a good or service with
cryptocurrency in and of itself can trigger a tax liability, where
that never happens with the U.S. dollar.
Aaron Kouhoupt: So Doug, if I’m
understanding that correctly, I just want to restate it as a very
much non-tax guy. If I receive $1,000 in cash, U.S. dollars, and I
hold onto that for a year; it’s still going to be worth $1,000.
If I receive cryptocurrency in the value of $1,000 equivalency, but
it’s a cryptocurrency, $1,000 worth of cryptocurrency, and that
cryptocurrency increases in value. So I have one Bitcoin, and the
one Bitcoin’s worth $1,000, that Bitcoin goes up to $1,400, and
I sell it. Does that mean I have $400 worth of taxable income
because the fair market value of the crypto went from $1,000 to
$1,400 when I sold it?
Douglas Charnas: Yes. That means that you have
a gain, and depending upon how long you hold that cryptocurrency
and whether that cryptocurrency is a capital asset for you, you may
have short-term capital gain or long-term capital gain, and the tax
rates will vary. You can really understand this if we put it into
the context of the $1,000 that you got for performing the services.
If you go and now purchase something with that $1,000, so let’s
say that you’re going to a hotel and you want to use your
$1,000 to pay for the room and you’re going to stay there for a
few days. So the cost of the room is going to be $2,000. Well, if
you’re using U.S. dollars, that means you’re going to have
the $1,000 that you earned, and you’re going to need another
$1,000 to pay for the hotel room. So you’re going to pay
$2,000.
But when you do that, you are not going to incur any tax
liability because you’re using U.S. dollars. But let’s go
back and say that $1,000 of cryptocurrency that you received when
you performed those services has now increased to $2,000, and
you’re going to pay for that hotel room with that
cryptocurrency. Well, what’s happening is you’re now going
to get taxed on that $1,000 increase from the original fair market
value of that cryptocurrency when you perform the service, to the
now fair market value when you are using that cryptocurrency to pay
for the hotel room. So the mere purchase of a good or service with
cryptocurrency in and of itself can trigger a tax liability, where
that never happens with the U.S. dollar.
The whole area of loyalty programs and rewards is
one for which we do not have much guidance from the Internal
Revenue Service. It’s a complicated area because it depends on
why you’re getting the reward.
Aaron Kouhoupt: Right. That makes a lot of
sense and is very good to know. So another thing that we’re
seeing a lot in the market is, you know, we see a bunch of
companies, typical traditional consumer finance companies or maybe
alternative consumer finance companies, that are offering
cryptocurrency as a reward. And so think about your, you know,
Delta miles or your Hilton honor points. This is similar in the
sense that I use a credit card or I use a debit card, and I earn $1
of crypto every time I make $10 worth of purchases with my card.
How is the crypto taxed from that perspective? If I’m earning
the cryptocurrency as a reward, what is the impact to me there?
Douglas Charnas: The whole area of loyalty
programs and rewards is one for which we do not have much guidance
from the Internal Revenue Service. We have some guidance, but not a
whole lot. It’s a complicated area because it depends on why
you’re getting the reward. If you are purchasing something,
you’re using your credit card, for example, and you’re
acquiring goods, you’re also going to be incurring service
charges and interest. That’s the purchase of a good or service.
And when you receive a reward in connection with the purchase of a
good or service, the reward is treated as actually an adjustment to
the purchase price. So the receipt of that award in those
situations does not trigger income for you. It’s really going
to be a reduction in the item that you purchased. The IRS, in its
Publication 17, which is sort of its general publication of the tax
law for individuals, provides an example.
One example of a reward that actually triggered
income for the recipient was a thank you point reward for airline
miles that was provided by a bank.
And there, it gives an example of a rebate by an automobile
manufacturer. You have a car worth $24,000; you purchase that car,
you get a $2,000 rebate from the manufacturer. Well, that rebate
that you receive, and it may be a cash rebate, is not income to
you. It’s just a reduction in the purchase price of that
automobile. So now your tax basis in that automobile is $22,000
because you reduce the $24,000 by the $2,000. In that context, you
don’t have gain. And it doesn’t matter whether you’re
getting cash or you’re getting cryptocurrency; it’s going
to be no income to you. But the difference again is that when you
get that cryptocurrency, that is worth $2,000. That’s your tax
basis in that $2,000. So if you now go out and you spend that
reward that you’ve received, and in your context, it’s
coming from a financial institution, then you may have gain or
conceivably loss, because you’re going to look at what’s
the fair market value of that reward at the time that you use it
compared to your tax basis.
There’s a different scenario which adds to the complexity,
and that’s a situation in which you get cryptocurrency or even
U.S. currency for doing something, but you’re not purchasing a
good or service. One example of a reward that actually triggered
income for the recipient was a thank you point reward for airline
miles that was provided by a bank. And when that individual
received that, there was going to be a question of whether he had
taxable income when he used that thank you reward to get airline
miles, and the Tax Court, in looking at that case, said yes, there
was income at that time. So the area is a little bit complicated.
What adds to the complexity for cryptocurrency or any type of
virtual currency is that you have to track the basis in that
cryptocurrency. So whenever you then spend it, now you have to
know, for that particular cryptocurrency, what was my tax basis in
that?
The IRS recently released a draft of the 1040, the
individual income tax return, and the (revised) question is, have
you received digital currency, or have you spent it? And it’s a
yes or no question; there’s nothing beyond
that.
And when I go to spend it, is that going to trigger gain or loss
for me? And this is the area that’s creating a lot of
administrative burden on taxpayers and the IRS. It’s the
tracking of that cryptocurrency tax basis. The IRS recently
released a draft of the 1040, the individual income tax return, and
it has revised the question that it has for virtual, or they refer
to it as “digital currency.” And that question is on the
return, right below where you fill out your name and your social
security number and your address. So it’s really the first
question on the tax return. And the question is, have you received
digital currency, or have you spent it? And it’s a yes or no
question; there’s nothing beyond that. But what that’s
telling the IRS is that you’re dealing with cryptocurrency and
that you may have gain or loss as a result of that.
Aaron Kouhoupt: Thanks, Doug. So if I take the
two things that you said together, what I think I’m hearing is
that, and let’s stick in this reward section for a second, the
timing of the purchase by the entity that’s going to grant the
reward and the timing by which the ownership of the cryptocurrency
exchanges hands becomes a little bit important. Because if I’m
the entity and I buy cryptocurrency, but I maintain ownership of
that cryptocurrency, let’s say I don’t transfer the crypto
reward to Doug until 60 days down the road, I, as the entity, hold
that cryptocurrency for 60 days. I own that cryptocurrency for 60
days, and if that cryptocurrency goes up or down during those 60
day period, it sounds like there could be a taxable event there for
me as the entity holding the cryptocurrency that I just purchased
on behalf of the consumer. Or I transfer the value of that
cryptocurrency immediately to Doug, in which case Doug then has the
potential tax implication as to whether or not that cryptocurrency
is going to go up or down. So it sounds like there could be some
important timing considerations from an accounting and financial
perspective, as to when that cryptocurrency is actually purchased
and then when the ownership of the cryptocurrency changes hands to
establish that basis of the fair market value of the
cryptocurrency.
The timing of the purchase by the entity that’s
going to grant the reward and the timing by which the ownership of
the cryptocurrency exchanges hands becomes
important.
Douglas Charnas: That’s absolutely right,
and that’s why it’s so important to have a system set up to
track all of these events. You need to know what the fair market
value is at the time that you acquire the cryptocurrency to use it.
And then you need to know because that establishes your tax basis.
And then, you need to know what the fair market value of it is when
you transfer it. Because as you said, Aaron, that’s going to
determine whether you have gain or loss on that transfer.
Aaron Kouhoupt: That all sounds interesting and
complicated, and I think that it seems pretty clear to me that the
best move you can make either as an entity that’s granting
rewards and buying cryptocurrency on behalf of another or if
you’re a consumer earning cryptocurrency through a reward just
every day, right, just getting cryptocurrency, that you might want
to talk to your tax advisor at the end of the year about what the
implications are.
You need to know what the fair market value is at
the time that you acquire the cryptocurrency to use it. You need to
know because that establishes your tax basis. You need to know what
the fair market value of it is when you transfer it. That’s
going to determine whether you have gain or loss on that
transfer.
Douglas Charnas: That’s absolutely right.
And you’re going to need to have good records. And I think what
concerns me is that the burden of establishing what the fair market
value was at the time that you acquired it for purposes of knowing
whether you have gain or loss when you dispose of it is going to be
on the taxpayer. If the taxpayer is being audited by the Internal
Revenue Service, the Internal Revenue Service may take the position
that the basis is zero, unless you can establish to me
otherwise.
Aaron Kouhoupt: Thank you very much for being
with us again today, Doug, and talking about these issues. And if
anybody has any questions, feel free to reach out to Doug or
myself, and I can get you in touch with Doug, because you don’t
want me giving you tax advice. Online tax preparing software is the
way I go. So we’ll get you in touch with Doug, and he’ll
help you out.
Douglas Charnas: Glad to be with you, Aaron.
Take care. Thanks.
Aaron Kouhoupt: Thanks.
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