Planning for Virtual Currency

Virtual currency (also known as cryptocurrency), such as Bitcoin, has been increasing in popularity. Virtual currency may be used to pay for goods or services, or held for investment. Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like “real” currency. For federal tax purposes, virtual currency is treated as property. As such, it can be classified as business property, investment property, or personal property. General tax principles applicable to property transactions apply to transactions using virtual currency.

Basis in virtual currency is the Fair Market Value (FMV) of the currency on the date it is received. If you receive virtual currency as payment for services, it is considered taxable income and will be subject to both income and Social Security taxes. Also, using virtual currency to obtain cash or purchase goods is a recognizable transaction. If the FMV of property you receive for the virtual currency exceeds your adjusted basis in the currency, you will have a taxable gain. A loss will occur if the FMV is less than your basis. The character of the gain or loss depends on whether the virtual currency is considered your capital asset.

One strategy to reduce your 2022 tax liability on virtual currency transactions is to use the Highest-in, First-out (HIFO) accounting method. To use this method, you will need to specifically identify which units you are transferring in the transaction. You also will need to keep detailed records of all virtual currency purchases to substantiate your basis on sale. If you do not keep detailed records, the IRS will default to the First-in, First-out (FIFO) method, which may result in a larger gain in 2022. Fortunately, since virtual currency is considered property and not stock, the wash sale rules do not apply, making it possible to harvest losses on some of your units and then repurchase the same units immediately. (Note there have been legislative proposals to apply the wash sale rules to cryptocurrency, but none have passed to date).