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Since 2014, U.S. tax law recognizes cryptocurrencies not as foreign currencies but property, like tulips. On Notice 2014-21, the IRS stated that part of the reason for its decision was that virtual currencies do not have legal tender status in any jurisdiction.
Since then, the country of El Salvador has given Bitcoin legal tender status. Another country, the Central African Republic, also adopted Bitcoin as legal tender in 2022 but reversed its decision last March. While no other country has given cryptocurrencies like Bitcoin legal tender status, most have regulated its use in some form.
Just recently, the IRS issued Notice 2023-34, where it acknowledges that some countries have enacted laws that characterize Bitcoin as legal tender. Regardless, it will continue to treat Bitcoin and similar cryptocurrencies as property.
To understand the decision, let’s compare the tax consequences of cryptocurrency transactions under the foreign currency laws versus the current property rules stated in Notice 2014-21.
Under the current guidelines, cryptocurrencies would be treated by the IRS like a capital asset unless they are in the trade or business of investing in cryptocurrencies. If the cryptocurrency is purchased and later sold, traded, or used to make another purchase, then there will be either a capital gain or loss depending on the value of the cryptocurrency at the time of sale, trade, or purchase.
If the cryptocurrency is held for less than one year, it will be taxed at ordinary income rates. If it was held for more than one year, the gain will be taxed at the more favorable long-term capital gains rates.
If there are capital losses, they can offset similar capital gains and any leftover losses are carried forward indefinitely. The capital losses can only offset $3,000 of ordinary income in a taxable year.
On the other hand, if cryptocurrencies are considered foreign currencies for tax purposes, they could be subject to what is known as “988 transaction” rules, named after the tax code section governing foreign currency transactions. Under these rules, if a cryptocurrency is purchased and later sold, exchanged or used to make a purchase, any gain or loss will be treated as an ordinary gain or loss regardless of how long it was held.
Foreign currencies are exempt from ordinary gain (up to $200 not adjusted for inflation) if the gain came from a personal transaction. A personal transaction is defined as a transaction that is not connected to a business or investment activity. This will cover most purchases with foreign currencies or converting foreign currencies back into U.S. dollars. On the other hand, this exemption will not apply to foreign currency dispositions done with the intent of making a profit.
Whether the cryptocurrency is treated like property or foreign currency, if someone is compensated with cryptocurrencies, its value in U.S. dollars is taxable income upon receipt. It may also be subject to self-employment or payroll taxes depending on whether the recipient is an independent contractor or an employee.
For most crypto investors, they would not want their cryptocurrencies to be taxed like foreign currencies as their gains are likely to be taxed at a higher tax rate. On the other hand, they would want this treatment if they had large crypto losses and want to use it to offset ordinary income from other sources, like their day job.
And as most holders of crypto are holding them for investment purposes, they cannot take advantage of of the $200 exemption mentioned above. But the exemption is available if they used the currency to purchase dinner.
For the taxpayer who conducted their cryptocurrency transactions exclusively in El Salvador and wants foreign currency tax treatment (assuming it is tax-favorable), an argument can be made that Notice 2014-21 should be invalidated since it conflicts with federal statutes that address foreign currency transactions. Bitcoin in this case would be considered a “nonfunctional currency” and the IRS should treat it as such.
There are some unanswered questions, particularly involving cryptocurrency transactions that are not mentioned in Notice 2014-21 such as forward contracts, options, or hedging transactions to name a few. Assuming the results will be tax-favorable, can someone rely on the foreign currency tax laws to structure their crypto transactions? If the interest is strong enough, the IRS may issue another notice to answer this question.
So it appears that the IRS will stand by its “cryptocurrency is property” likely because only one country is treating it like real money. But will the IRS change its tune if more countries adopt cryptocurrencies? Or what if a G20 or OECD country does so? While giving foreign currency tax treatment might give a symbolic victory for those seeking crypto legitimacy, the rules do not really seem to benefit crypto investors as their profit will be subject to higher tax rates.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.
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