Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency ("real currency"), that functions as a unit of account, a store of value, or a medium of exchange.
-IRS
While virtual currency has been around since 2009, it has become better know over the last couple of years. Although there are now dozens of them, some of the most popular names are bitcoin, ethereum, dogecoin and litecoin.
All convertible currency such as cryptocurrency is considered a capital asset for most taxpayers. You invest in virtual currency in the hopes that it will increase in value.
The price of a cryptocurrency is based on one unit, and the pricing is based on the per-unit value, which goes up and down just as a unit of stock would on a stock exchange.
You might receive virtual currency as gifts or inheritances. Remember that virtual currency is, for tax purposes, a capital asset and that the rules for receipt of other types of capital assets or property through gifts or inheritances will also apply to virtual currencies.
You can invest in virtual currency through third-party companies, like Robinhood. Many traditional brokerage firms now also offer trading options for buying and selling virtual currency.
You can also buy goods and services with units of virtual currency and have a taxable gain. When this occurs the buyer's basis in units spent must be assessed against the value received to calculate if there is a gain or loss on the transaction. A capital gain or loss is recognized as a result, based on the difference between the taxpayer's basis in the virtual currency and the fair market value of the goods or services for which it is exchanged. Consider this to be an exchange of one type of property , the virtual currency, for another type of property, the goods or services receive.
Every transaction must be tracked and evaluated for gain or loss. Needless to say, if you purchased a lot of things with your virtual currency, the paperwork could get quite complicated.
The same is true for the trading of one type of virtual currency for another type of virtual currency. It is considered an exchange for one type of property for a different type of property. The basis of the virtual currency traded must be subtracted from the FMV of the new virtual currency acquired.
Like all capital assets, the basis of virtual currency depends on how it was received. This means that virtual currency acquired by purchased will generally have a basis equal to way you paid for it. It it's acquired by inheritance, it will generally have a basis equal to the fair market value at the time of the decedent's death. It it's received as a gift, it will follow the gift rules.
Some people may be investing in virtual currencies in the same way they do stocks and bonds, hoping to make money through holding and selling it at a higher value. Other people will simply be acquiring virtual currency as a personal convenience for transactions.
Others may feel that it is a way to avoid the traditional banking systems, rules, and regulations associated with traditional banking, and yet others may be getting their feet wet in virtual currency because it is new and different, and they see themselves as innovators.
Regardless of which way you use virtual currencies, IRS regulations state that if you sell, exchange, or inherit any virtual currency, you will need to report it on your tax return when it is sold. The gains or losses are usually reported on Form 8949 and carried to Schedule D.
Accurate record-keeping is required and begins with the taxpayer's basis in the virtual currency owned. You must keep track or use a company that provides you with year-end statement. You must know how much you bought, on what date, and at what value in order to report the disposition of that capital asset in the future.
Keeping track of details surrounding these assets are critical for the future when you may want to minimize your potential tax liability on any gain at the sale or exchange of these capital assets.