Amy operated a successful Manhattan restaurant. One day, in the summer of 2010, she received an odd request from a potential customer. He called in a takeout order and was interested in paying with Bitcoin. Having heard of Bitcoin, and willing to take a risk on a small order, Amy accepted the order and received payment of 5,000 Bitcoins in exchange for the entrée. On the date the purchase was made, the fair market value of 5,000 Bitcoins was $20.
Although amused by the transaction, Amy filed away her receipt and forgot about her modest Bitcoin holding until a news article discussing the rising value of cryptocurrencies caught her eye three years later. After digging up her information, Amy was elated to find that her 5,000 Bitcoins were now worth $3,000,000. Amy decided that she did not want to risk a tremendous loss in value by holding onto the Bitcoins for any longer. She quickly decided to sell the Bitcoins, putting some of the cash toward paying off loans and using the rest to expand and improve her restaurant.
Having sold the Bitcoins for $3,000,000, with a cost basis of $20, Amy incurred a capital gain of $2,999,980. At the top capital gains rate of 23.8%, Amy had a tax bill of $713,995 from the sale. She therefore received $2,286,005 from the sale of her once $20 asset.
Example 2Determining the capital gains allocated to a cryptocurrency can be relatively straightforward. For cryptocurrency acquired by purchase, the owner's cost basis is equal to the amount paid for the property. The cost basis of a cryptocurrency received as a payment for goods and services is the fair market value of the cryptocurrency on the date of receipt. However, there are other ways a taxpayer may acquire cryptocurrency, which can make the valuation process more difficult.
Instead of selling her 5,000 Bitcoin, Amy's tax advisor recommends that she consider creating a charitable remainder unitrust with a portion of her cryptocurrency and sell a portion. This strategy will allow her to offset a portion of her capital gains tax from the sale of her Bitcoin holding with a charitable deduction. She would receive an immediate lump sum of cash from the sale and lifetime payouts from the unitrust. Working with her advisor, Amy determines that she can zero out the taxation on the sale of $1,120,500 worth of Bitcoin if she uses $1,879,500 to fund a one-life charitable remainder unitrust. She will bypass a portion of her capital gains by funding the unitrust and will receive an initial annual payout of $93,975, which could increase over time, depending on the performance of the trust's investments. Given her age at the time the trust is created, she may have 30 years of payouts, potentially totaling $3,263,000.
Example 3In a letter dated March 19, 2018, the American Bar Association (ABA) Section of Taxation submitted comments to IRS Acting Commissioner David Kautter, seeking updated IRS guidance on cryptocurrencies and offering recommendations, specifically related to the tax treatment of cryptocurrency hard forks. Among its suggestions, the ABA recommended that the IRS create a temporary safe harbor for cryptocurrency holders who experienced a hard fork in 2017. The ABA Section of Taxation cited "difficult timing and valuation issues" as the impetus for the suggested safe harbor rule. The date on which an owner takes possession of a unit of cryptocurrency has been the subject of debate and may depend on whether the owner holds the unit directly or through an intermediary. A similar difficulty arises as to the valuation of the new cryptocurrency, as there are various online exchanges, each of which may provide a different estimated value on the starting date.
Tim purchased three units of the latest and greatest cryptocurrency, OldCoin, a few years back for a total of $300 as a long-term investment. The value of Tim's three units of OldCoin has reached $8,200. Tim is aware that OldCoin experienced a hard fork on the first day of December and decided to meet with his advisor to determine the effect of the hard fork on his small cryptocurrency investment. Tim's advisor explains that, due to the hard fork, Tim now owns three units of OldCoin and three units of NewCoin. The advisor then tells Tim that he may need to report the value of the new cryptocurrency as ordinary income on his tax return. Tim and his advisor determine that each unit has a fair market value of $250 on the date of the hard fork. Because Tim holds three units of an entirely new asset at $250 per unit, he will recognize an additional $750 in income for the year. Tim accordingly reports the small bump in income for his 2017 taxes.
Tim decides to hold onto the three OldCoins and three NewCoins for five years, at which point his original three units have appreciated to a total value of $20,000. His newer cryptocurrency has reached a fair market value of $10,000. Eager to cash in on his modest $300 investment, Tim decides to sell all six of his cryptocurrency units for a total of $30,000. He returns to his advisor and asks what the tax consequences of the sale will be. Because Tim has held the cryptocurrency for more than one year, his advisor explains that Tim will be taxed at long-term capital gains rates for the sale. Tim's basis in his OldCoin units will be the $300 that he originally invested. Therefore, he will have $19,700 in taxable capital gains upon the sale. His NewCoin units have a cost basis of $750, with capital gains of $9,250.
Example 4The ABA's request for updated IRS guidance is just one of many attempts to clarify the tax treatment of cryptocurrency. The IRS has not responded to the ABA's request, or other similar requests for guidance, choosing instead to remain silent in the years following the release of Notice 2014-21. Professional advisors, therefore, are left to determine the proper treatment of their clients' cryptocurrencies by applying general principles of law, despite the fact that those general principles may not be directly on point for this relatively new type of asset.
Instead of treating the NewCoin as an accession to an additional $750 of wealth in the tax year, Tim and his advisor decide to take a more aggressive approach and claim that Tim's three units of NewCoin had a zero basis on the date of the hard fork. Therefore, his adjusted gross income for the year is not affected by the hard fork. When Tim sells his NewCoin holdings five years later for $10,000, however, he will recognize $10,000 in capital gains.