Cryptocurrency Generation and Taxation January 31, 2018

New cryptocurrency investors and CPAs alike have questions about how digital currency tokens are created, traded, and taxed. Below, we’ll give an overview of how miners acquire derivatives of a cryptocurrency token, as well as a brief synopsis of what the IRS has said so far regarding the taxation of gains on the trading of digital currencies. 

How cryptocurrencies generate value 

Unlike a traditional monetary system like the Federal Reserve where a centralized authority decides when to print currency, cryptocurrency tokens are mined by users that utilize specialized software to connect to a network (and often allow their computer to become a “node” in the network) and in return receive a small derivative of the token. The miners are actually settling the transactions that are occuring in real time in the blockchain. This settling process is what actually moves these tokens from one account to another. The mining process is similar to how credit card companies or banks settle a customer’s daily transactions.  

This system incentives users to become active on the network, which in turn secures the network against any type of nefarious attack, such as hacking or manipulation. Any attempt to covertly modify a transaction will result in immediate rejection of the transaction. All transactions must conform to strict cryptography standards, which are mathematically impossible to counterfeit. Once mined, the owner of the token is then free to either keep the token in hope of a future return, or sell the token in somewhat the same manner a traditional investor would with a stock.  

Since wealth is being generated, taxes will be paid 

As activity and values related to cryptocurrencies are both trending upwards, so is the IRS’ attention to issues related to the taxation of gains. As a completely new way of generating wealth, which operates outside of traditional banking systems, questions abound as to how it will be taxed. As people are exchanging tokens for large financial gains, rest assured—as with any other type of income—governments will make sure they get their cut. 

The IRS has stated that even though some vendors will accept digital currency in lieu of “real” currency, the general tax principles that apply to property transactions apply to transactions that utilize virtual currency. Even exchanging one digital currency for another will trigger a capital gain calculation. The amount of time that an investor holds the currency is also privy to the rules of short-term vs. long-term capital gains. In a nutshell, cryptocurrency transactions are treated almost identically to traditional security transactions. The income a miner generates related to their mining activities is subject to standard self-employment taxes. As the use and exchange of cryptocurrencies rapidly expands, CPAs will surely need to perform their due diligence with regards to IRS regulations on how to treat clients’ financial aspects related to this new type of taxable income. 

Just scratching the surface 

Above, we’ve described the concepts related to cryptocurrency mining and taxation in the most basic terms possible. The technology behind these concepts appears relatively complicated; thankfully, understanding this aspect is unnecessary for most of us. But, understanding that digital currencies are here to stay, is important.

As a CPA, you’re sure to come across clients who are investing in this realm. Like any other financial aspect related to your clients, it will be important to become informed so that you can give sound, accurate advice and keep them in the good graces of the IRS.