In 2014, the IRS issued Notice 2014-21, 2014-16 I.R.B. 938 explaining that virtual currency is treated as property for Federal income tax purposes and providing examples of how longstanding tax principles applicable to transactions involving property apply to virtual currency. With our income tax authorities going to bite virtual currency as explained in the recent budget 2022-2023, let us learn from United States Internal Revenue Service web site, Questions & Answers on virtual currency. Though published in 2014, it is updated. Don’t ask me why they ventured to the area not many would think at that time.
Moreover, who knows our tax authorities would definitely refer to this communication for giving their own clarifications as revealed repeatedly in the past two days or not.
Questions & Answers on virtual currency (Contained in 46 questions, I shall deal with it as I progress). Some answers are the quotations from source of IRS. Somewhere, I do explain to make it simple. Yes, understanding the basics is very important.
1. What is a virtual currency?
Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”)
It functions as a unit of account, a store of value, and a medium of exchange. Some are convertible in real currency or act as a substitute for real currency.
The IRS uses the term “virtual currency” in these FAQs to describe the various types of convertible virtual currency.
Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purpose.
2. How is it treated for income tax purposes?
Virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency. Is it like a share purchased? Yes.
3. What is cryptocurrency?
Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.
A transaction involving cryptocurrency is recorded on a distributed ledger which is referred as an “on-chain” transaction.
A transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.
4. Now many real-life situations may happen. How to find guidance from tax authorities.
Will I accept gain or loss if I sell my virtual currency for real currency?
Yes. When you sell virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses.
5. Let us imagine a position for 2020 Form 1040(individual income tax which has been extensively dealt with by myself).
It asks whether I received, sold, exchanged, or acquired any financial interest in a virtual currency. During 2020 I purchased virtual currency with real currency. Then what is the legal position?
If you have just purchased virtual currency with real currency, you may not report anything in tax form 1040 for 2020. Since no gain or loss happened this situation arises.
6. How do I determine my gain is short-term or long-term and similarly the loss position?
If you held the virtual currency for one year or less before selling or exchanging the virtual currency, then you will have a short-term capital gain or loss.
If the holding period is more than one year, it is a long term. How does one determine the long term? An apt answer with the information that the period during which you held the virtual currency (known as the “holding period”) begins on the day after you acquired the virtual currency and ends on the day you sell or exchange the virtual currency. It is not on the day you purchased the virtual currency.
Could you notice the subtle difference?
Now the next situation.
7. How do I calculate gain or loss when I sell a virtual currency with a real currency?
I shall simply quote the official position “Your gain or loss will be the difference between your adjusted basis in the virtual currency and the amount you received in exchange for the virtual currency, which you should report on your Federal income tax return in U.S. dollars”
You may recollect that many of earlier articles do deal with gain or loss either short term or long term though now we deal with virtual currency. Yes Sir, virtual currency. If you do not understand, please read question No.1.
8. Now, the other position to know the basis in my virtual currency when it was purchased with real currency.
Your basis (also known as your “cost basis”) is the amount you spent to acquire the virtual currency, including fees, commissions and other acquisition costs in U.S. dollars. Your adjusted basis is your basis increased by certain expenditures and decreased by certain deductions or credits in U.S. dollars.
9. An interesting question. I just provide my services and is being paid by virtual currency. Then what?
For both situations where the service is returned with property or virtual currency, which may or may not qualify as an employee, it is a simple income. It is very common to find one’s services for religion or an NGO in U.S.A. for similar description.
10. What about one receiving virtual currency for services rendered as self- employment income?
Now more realistic situations. You may recollect that you do report self-employment in form 1040.
With gross income in self-employment being as understood by us, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income.
You are too subjected to the self-employment tax.
11. Yes, with the employer deciding to pay virtual currency for an employee, how do I explain?
Let us be clear that the medium in which the remuneration for services is paid is irrelevant. Consequently, the fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement.
Yes, all this covered under form 1040. Let us not forget.
12. How do I calculate my income if I provide service/receive income in virtual currency?
The amount of income you must recognize is the fair market value of the virtual currency, in U.S. dollars, when received. In an on-chain transaction you receive the virtual currency on the date and at the time the transaction is recorded on the distributed ledger.
This is simple common sense that the medium of transaction in case of virtual currency is the distributed ledger. Any technical person dealing in distributed ledger will understand this simple explanation.
13. Let me know the basis of the virtual currency I receive for the services rendered.
Fair market value of the virtual currency in US dollars received as on date of receipt for the services rendered.
14. Another interesting question. When I pay someone with virtual currency for the services rendered, do I recognize capital gain or loss?
Let us be very clear. Virtual currency is a capital asset and obviously invites capital gain/loss on that date of exchange.
15. If I pay by virtual currency for the services rendered by some- one how do I calculate the loss/gain?
The difference between the adjusted basis of the virtual currency already known to me and the fair market value of the services got will result in gain/loss.
16. What happens when virtual currency is exchanged for some other property?
The difference between the capital gain/loss of the capital assets involved result in gain/loss. Many of the questions in a flow lead us to a simpler plain where one can easily detect the issues involved and solve them.
17. Let us have a vice versa position. If I purchase a capital asset for virtual currency from my side.
Fair market value of the capital asset purchased and the adjusted basis in the virtual currency with me exchanged constitute the capital gain/loss.
Let me also deal with other question.
What will happen if the mode of exchange of virtual currency is in currency other than US Dollar?
With the global world and more and more countries hurrying up to look up for transactions involving virtual currency in all countries, let us look at the resultant gain or loss, if any.
For the question mentioned above, the answer is Yes. For capital asset exchange with virtual currency, it is capital loss/gain while for others, it is ordinary gain/loss.
If I get virtual currency for a property exchange, the fair market value of virtual currency is its basis.
What do I get if one of my crypto currencies went through a hard fork but no new cryptocurrency?
Let us understand a detailed technical explanation.
A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger.
This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income.
Good news is that no taxable income due to airdrop or some other kind of transfer, and receipt of no cryptocurrency.
What is the basis of my cryptocurrency received after hard fork?
I include the fair market value of new cryptocurrency received in the distributed ledger with time and date of air drop which is included in my tax return filed with IRS. This will be the basis of my cryptocurrency.
Now let us go to the platform through which I get a cryptocurrency: a cryptocurrency exchange. What will be its market value at the time of receipt?
Yes, the fair market value of the transaction recorded by the exchange in US dollars will be its value.
In case, If the transaction is facilitated by a centralized or decentralized cryptocurrency exchange but is not recorded on a distributed ledger or is otherwise an off-chain transaction, then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction.
Yes, complications will form the basis of cryptocurrency transactions for which professional help like a highly matured CPA with the best professional tools will be required.
What about receipt of cryptocurrency received in a peer-to-peer transaction or some other way not involved in a cryptocurrency exchange?
The fair market value of the cryptocurrency is determined as of the date and time the transaction is recorded on the distributed ledger or would have been recorded on the ledger if it had been an on-chain transaction.
Anyhow, it is the person receiving the cryptocurrency who must prove its fair market value in a way acceptable to IRS.
Since there are 46 questions and answers, I intend covering them in another article. However, today’s discussion in Economic Times dated February 4 2022 attracts my attention which is related to news item titled “Missing word crypto in Law sets off alarms” on last page of the news paper with caption “Disruption: Startups and Tech”
It is written that broad definition of virtual digital assets could cover digital assets of multinationals. The word cryptocurrency was found missing in the new regulation. There is a feeling that taxmen would vie for maximum taxation using their own interpretations.
Let us compare the above with American taxation discussions that we had by the way of questions and answers.
It is clear from our whole arguments from various questions that crypto currency is not a singular concept.
Virtual digital assets mean various explanations including digital currency. Why only cryptocurrency?
Still, Indian taxation had a few days to venture into virtual digital assets and that too after the budget which needs to be approved by the parliament.
I am confident that any virtual assets more than one year would mean long term asset value and long- term gain basis. I shall wait for passing of our budget 2022-23 and shall write another article covering Indian position on taxation related to virtual assets in near future.
Conclusion
The purpose of this article is the new interest shown by our investors who have purchased virtual assets through various crypto platforms and who want legal recognition of the same by the central government or RBI through its regulations.
It has been decided that RBI would create virtual currency for India which will have enormous applications including wiping out production of rupee notes to a greater degree. Imagine a situation every thing can be studied by legal authorities on real time basis with no necessity for me as a taxpayer to justify my income. This will necessitate no filing of tax returns for most of taxpayers.
Future is uncertain with too many transactions in distributed ledgers in chain reaction using the best technology with virtual human beings if possible.
Reference : IRS Website -https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions | IRS Publication 551, basis of assets.
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