The 1040 Virtual Currency Checkbox Question: Yes or No?

The 1040 Virtual Currency Checkbox Question: Yes or No?

A new checkbox figures prominently on the 2020 Form 1040. It asks "At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?" The checkbox has left some taxpayers wondering whether they should check "yes" or "no," and the IRS has provided some answers.

What Is Virtual Currency?

Virtual currency or digital currency, is basically a digital way to represent value. Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Most well-known types of virtual currencies such as Bitcoin and Ethereum, are cryptocurrencies.

How Is Virtual Currency Treated for Tax Purposes?

The IRS treats virtual currency as property for tax purposes.  A taxpayer who receives virtual currency in payment for goods or services has gross income equal to the currency's fair market value, as measured in U.S. dollars. A taxpayer who exchanges virtual currency for property has gain or loss if the fair market of the property received differs from the taxpayer’s adjusted basis in the virtual currency.

Reporting Virtual Currency Transactions

Taxpayers must report income, gain, or loss from all taxable transactions involving virtual currency on their federal income tax return for the year of the transaction, regardless of the amount or whether the taxpayer receives a payee statement, such as a Form W-2 or information return, like a Form 1099-MISC.

Individuals who transact with virtual currency, including buying and selling virtual currency or exchanging virtual currency, hold the virtual currency as a capital asset and the transactions result in capital gain or capital loss. Virtual currency received as compensation for services is treated the same as wages and results in ordinary income to the recipient who then holds the virtual currency as a capital asset. Individuals use Form 8949, Sales and Other Dispositions of Capital Assets, to report most sales and other capital transactions and calculate capital gain or loss. These capital gains and deductible capital losses are then summarized on Schedule D, Capital Gains and Losses, and reported on Form 1040.

1040 Instructions for the Checkbox

The instructions for Form 1040 direct the taxpayer to check the “Yes” box next to the question on virtual currency if the taxpayer "engaged in a transaction involving virtual currency." The instructions mention the following as included within the definition of transaction:

• an exchange of virtual currency for goods or services;
• a sale of virtual currency;
• an exchange of virtual currency for other property, including for another virtual currency;
• a disposition of a financial interest in virtual currency; and
• the receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or hard fork.

Comment: A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change that results in a permanent diversion from the legacy or existing distributed ledger. An airdrop is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.

According to the instructions, a transaction involving virtual currency does not include the holding of virtual currency in a wallet or account, or the transfer of virtual currency between wallets or accounts that the taxpayer owns.

IRS FAQ Provides Clarification

Virtual currency gained further popularity in 2020 as the market skyrocketed, bringing in many new investors. This left some wondering whether the purchase of virtual currency is a transaction requiring them to check "yes" to the question on Form 1040. The IRS added an answer to the Virtual Currency Frequently Asked Questions page regarding the purchase of virtual currency. According to the frequently asked questions, for taxpayers who hold virtual currency as a capital asset, if the taxpayer's only transactions involving virtual currency during 2020 were purchases of virtual currency with "real" currency (e.g., dollars), the taxpayer is not required to answer yes to the Form 1040 question.