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Fresh out of college, Alan purchased 20 Bitcoin in 2015 for $250 each. By the end of 2017, Alan was shocked to find out that the total value of his initial investment of $5,000 had ballooned to $380,000. Wanting to pay down his student loans, Alan quickly decided to sell 5 Bitcoin for $95,000. He used the sale proceeds to pay off his loans and used the excess to buy himself a late-model used car. Alan was surprised at tax time to find out that he owed $14,062.50 in capital gains tax.Because cryptocurrency is subject to the tax rules for property, a taxpayer who holds cryptocurrency must be cognizant of the potential capital gains ramifications of the sale of the property. Due to the volatile nature of the cryptocurrency market, there is likely to be an inherent tension between locking in gains and having to pay ordinary income tax rates on the sale of the cryptocurrency.
In early 2021, the price of Bitcoin began to rise again. As Bitcoin neared $60,000 in value, Alan was interested in capitalizing on the skyrocketing prices. He had seen how quickly the peak value of Bitcoin dropped in the past and he was eager to lock in his gains. But, on the other hand, he remembered the high capital gains tax he paid last time. Alan reached out to his professional advisor to ask whether there was a solution that would allow him to sell some Bitcoin without having a huge capital gains tax bill. The advisor encouraged him to consider donating some Bitcoin to a nonprofit to offset the gain from his proposed sale of Bitcoin. Through this plan, Alan reached out to a local nonprofit to ask whether they would accept a gift of cryptocurrency. The nonprofit happily obliged.
Following his advisor's advice, Alan donated 3 Bitcoin to the local nonprofit and sold 5 Bitcoin. The average of the high and low value of Bitcoin on the date of sale was $63,000. Alan received $315,000 for the 5 Bitcoin he sold and incurred capital gains tax of $59,220 on the sale. He was able to claim a $189,000 charitable income tax deduction for the 3 Bitcoin he donated to the nonprofit, saving $45,360 in taxes. Because this was a gift of a noncash asset, Alan was able to use this deduction up to 30% of his adjusted gross income for the year. Over several years, he took the deduction and partially offset his capital gains tax of $59,220 from the sale of the 5 Bitcoin.
Mario recently became interested in cryptocurrency and decided to start out the new year by investing in Dogecoin. As a "joke cryptocurrency," it was valued at merely $0.0045, but he liked the idea of telling his friends that he owned 100,000 Dogecoin. So, on January 1, 2021, Mario purchased 100,000 Dogecoin for $450. On April 16, 2021, the value of Dogecoin reached $0.43. Mario was astounded when he realized that his Dogecoin holding was now worth $43,000. Afraid that Dogecoin might soon return to its recent value between $0.03 and $0.05, Mario immediately sold 95,000 Dogecoin for $40,850.For the 2020 tax filing season, the IRS updated Form 1040, moving the following question from Schedule 1 to the first page of the form, "At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?" This question, as it is currently worded, has raised important questions from taxpayers and advisors regarding the tax treatment of cryptocurrency purchases. Typically, the acquisition of property is not a taxable event for the taxpayer. It is only the subsequent sale of that property that potentially triggers taxation.
Realizing that he had quickly turned $450 into more than $40,000, Mario decided to hire a tax professional. The tax professional explained that Mario's purchase and sale of the cryptocurrency in less than one year's time would lead to the $40,850 gain being taxed as ordinary income. On top of his $60,000 salary, Mario now had $100,850 in ordinary income for the year. This bumped him from the 22% tax bracket to the 24% bracket. Mario's tax professional explained that if he were to try to offset the taxable gain by making a charitable donation of the remaining 5,000 Dogecoin valued at roughly $2,000, he would only receive a deduction based on his cost basis of $22.50. The advisor explained that Mario would be better off donating a portion of the cash proceeds of the sale. In 2021, cash donations to public charities may be deducted up to 100% of the taxpayer's adjusted gross income.
Q5. The 2020 Form 1040 asks whether at any time during 2020, I received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. During 2020, I purchased virtual currency with real currency and had no other virtual currency transactions during the year. Must I answer yes to the Form 1040 question?While FAQ pages from the IRS do not bear the same authoritative weight as regulations, revenue rulings or notices, they can provide helpful, informal guidance. The Service's virtual currency FAQ page notes that the questions and answers "expand upon the examples provided in Notice 2014-21 and apply those same longstanding tax principles to additional situations."
A5. No. If your only transactions involving virtual currency during 2020 were purchases of virtual currency with real currency, you are not required to answer yes to the Form 1040 question.