Virtual Currency 101: Terminology, Taxation and Guidance

Virtual currency (such as Bitcoin) has been booming this past year. People have made sizeable investments in the emerging market, some of which have earned thousands (if not millions) of dollars in gains.

However, most investors have yet to test the waters due to uncertainty and lack of knowledge about the new market. To fully understand what virtual currency entails, know the terminology frequently used by its traders and the tax implications involved.

Blockchain

A blockchain is a database that composes all of the transactions ever made in a particular virtual currency. When a transaction is entered, it’s transmitted to a decentralized network of peer-to-peer computers that validify the transaction by solving a combination of equations. Once transactions are validated, they’re grouped into blocks and permanently chained to other blocks when filled. Blockchains are not only used for cryptocurrency, but also for other secure transactions like legal contracts and product inventories.

Mining

Mining is the process of verifying new transactions on a blockchain. Miners receive portions of crypto for completing verifications of each transaction. Validating transactions requires specialized, high-end computers to solve sets of complex algorithms. This is known as a proof-of-work system, which essentially secures the transaction and protects it from malicious tampering. This process is what has made cryptocurrency so secure, but it’s also costly in other ways.

Gas Price

When you make a transaction on certain blockchains (like Ethereum), a fee is associated with it. This fee is known as the gas price—a payment set by miners to compensate themselves for their energy costs (known as gas) associated with mining/validating transactions. You may have seen the term gas limit thrown around as well. This is the maximum gas price the person creating the transaction is willing to pay. A higher gas limit results in more work that can be done to execute the transaction.

Taxation

According to IRS Notice 2014-21, virtual currency is treated as property for tax purposes. This means you must report on your income tax return the fair market value of virtual currency at the date of payment or receipt in U.S. dollars. If virtual currency is exchanged for other property and the fair market value of that property exceeds the adjusted basis of the currency, you have a taxable gain; if it’s less, you incur a loss. Additionally, payments made using virtual currency are subject to the same backup withholding as other payments made with property.

Guidance

While guidance surrounding the taxation of virtual currency has been slim in recent years, we can expect more in the near future. President Biden’s 2022 budget proposal allows additional funding for the IRS’s guidance on tax compliance regarding virtual currency. In fact, we’re already receiving recent crackdowns from the IRS in April and May regarding two IRS summons for customer records surrounding Circle and Kraken crypto exchanges.

The Treasury Department has also released the American-Families-Plan-Tax-Compliance-Agenda. This proposal would require all financial institutions, including crypto asset exchanges, to report to the IRS gross inflows and outflows on all business and personal accounts.

With the increasing interest and guidance from the IRS, it’s important to consult your tax adviser for any virtual currency transactions you have performed (or plan on performing in the future). This information is constantly updating and could easily change in the upcoming days or weeks.

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