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Anyone who dealt with crypto taxes for the 2017 tax year knows the meager rules we have now are an absolute wreck.
There is a complete lack of regulatory clarity on how to treat the taxation of Bitcoin and other cryptocurrencies. That's left many crypto investors guessing about how to fill out their returns.
Editor's Pick: The Best Cryptocurrencies to Buy in 2018
The only guidance from the Internal Revenue Service came in 2014, when it declared virtual currencies "property" for the purposes of taxation.
That means profits made from buying and selling cryptocurrencies are subject to capital gains taxes.
That sounds simple, but in the real world, it isn't. People don't simply trade cryptocurrencies like they do with stocks.
You can use cryptos like Bitcoin and Ethereum to buy other cryptos. You can use cryptos to buy goods and services. And you can get "free" cryptocurrencies from events like hard forks (when a new version of a cryptocurrency splits off from an existing one) or airdrops (cryptocurrency awarded to a user who can meet certain qualifications, such as owning Bitcoin).
The IRS hasn't offered clarity on how it wants taxpayers to handle these situations. But leaving these details to individual taxpayers just isn't going to work. People need guidelines.
And after this tax season, the IRS won't be able to put it off any longer. The huge gains in crypto in 2017 – Bitcoin rose 1,000%, while the rest of the crypto market increased in value by more than 16,300% – generated substantial profits for many taxpayers.
Complications and confusion arising from the 2017 returns will give the IRS (and the U.S. Congress) a powerful incentive to come up with answers before the start of the next tax season.
But they face a lot of challenges…
Why Crypto Taxes Are So Complicated
The most basic problem in figuring out how to tax cryptocurrencies is figuring out how to classify them.
Although the IRS has declared cryptocurrencies a property, other government agencies have disagreed.
The Commodity Futures Trading Commission (CFTC) considers digital currencies commodities.
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And in 2013, the Financial Crimes Enforcement Network (FinCEN) concluded that virtual currencies are indeed currencies but don't qualify as legal tender.
Other countries are also struggling with this. The United Kingdom and Germany have decided cryptocurrencies are "private money." In Japan, cryptocurrencies are assets. And Canada agrees with the CFTC in declaring cryptocurrencies as commodities.
While regulators strain to define crypto as something else they understand, they keep missing the obvious. Cryptocurrencies are a new type of financial asset. They can function as currencies, as commodities, as properties, and many more things beyond the financial realm.
The U.S. government needs to face the fact that cryptocurrencies can't be jammed into any existing investing classification. Cryptos require their own set of rules, particularly when it comes to taxation.
Of course, devising new, crypto-specific rules is a much heavier lift.
And there are tons of complications…
The IRS Has No Ready Answers for These Crypto Issues
Let's start with hard forks and airdrops, two ways crypto owners receive crypto at no cost.
Airdrops are coins a crypto investor can claim without having to buy them. This is pretty straightforward. The cost basis is clearly zero, and gains would be taxed when the obtained coins are traded or sold.
A hard fork is much more complicated.
When a hard fork occurs, anyone who owns the affected cryptocurrency receives an equal amount of the new, forked coin. But it's not like a stock split, in which an investor receives more shares that add up to the same value.
A hard fork creates a new, separate set of coins. It's free money.
But how do you tax it? Tax law suggests the investor owes taxes on the new coins just for receiving them. But how do you determine the taxable value? The price of a cryptocurrency can vary widely on different exchanges.
Hard forks also differ from stock splits in that the new coins aren't always easy to claim. Not all hard forks are widely known, either. An investor could be entitled to coins and not know it. That makes them difficult to include on your taxes.
What the IRS should do here is equate hard forks with airdrops. Call the cost basis zero, and tax the investor only when the coins are traded or sold. That removes liability for unclaimed hard fork coins an investor never realized they had.
Another complication arises from the global nature of cryptocurrencies…
Overseas Exchanges and a Suggestion Everyone Will Hate
It's very easy to open accounts with foreign-based cryptocurrency exchanges.
But holding crypto in a foreign-based account could trigger Foreign Bank and Financial Accounts (FBAR) and Foreign Account Tax Compliance Act (FATCA) reporting. I say "could," because even tax experts aren't sure whether these regulations apply to cryptocurrencies or not. If the rules do apply to crypto, it's possible withholding tax rules would kick in.
Obviously, the U.S. government needs to straighten this out (or specifically exempt cryptocurrencies).
One change bound to anger some – although I believe it would benefit most crypto investors – would be to require the exchanges to track all trading activity and submit a 1099-B-type form, just as brokerages do.
As it stands, crypto exchanges allow customers to download trading histories, but investors must track the gains and losses themselves.
This becomes particularly challenging in trades that involve two cryptocurrencies. The IRS requires the values to be reported in U.S. dollars, which means the taxpayer needs to record (or figure out later) what the U.S. dollar value was.
A 1099-B form would simplify the reporting of taxable crypto gains but goes against the privacy/anti-government philosophy many cryptocurrency advocates have. (It means the IRS would get the same data.)
That's why Coinbase fought the IRS in 2016, when it requested all customer records (last November, a court ordered Coinbase to turn over the records of the 13,000 customers who had made transactions worth $20,000 or more in a single year).
But the stickiest issue the IRS needs to deal with before tax time rolls around again has to do with what happens when investors use cryptocurrency to buy something…