According to Investopedia, virtual currency is a type of unregulated digital currency that is only available in electronic form. It is stored and transacted only through designated software, mobile or computer applications, or through dedicated digital wallets, and the transactions occur over the internet through secure, dedicated networks.

Virtual currency is considered to be a subset of the digital currency group, including cryptocurrencies, which exist within the blockchain network (a list of records, called blocks, that are linked using cryptography, or, if you prefer, digital information stored in a public database).

From the taxation point of view, the IRS further describes virtual currency as 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, and a medium of exchange.

The term “virtual currency” is also used to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency.

Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes.

Virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency.

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. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.

Units of cryptocurrency are generally referred to as coins or tokens.

Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places at the same time with no central data store or administration functionality.

A hard fork is unique to distributed ledger technology and occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. A hard fork may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger.

Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger and transactions involving the legacy cryptocurrency continue to be recorded on the legacy 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. Cryptocurrency from an airdrop generally is received on the date and at the time it is recorded on the distributed ledger.

As part of a wider effort to assist taxpayers and to enforce the tax laws in a rapidly changing area, the IRS issued new guidance for taxpayers who engage in transactions involving virtual currency.

Expanding on guidance from 2014, the IRS issued additional detailed guidance to help taxpayers better understand their reporting obligations for specific transactions involving virtual currency. The new guidance includes Revenue Ruling 2019-24 and frequently asked questions (FAQs). The new revenue ruling addresses common questions by taxpayers and tax practitioners regarding the tax treatment of a cryptocurrency hard fork. In addition, the set of FAQs address virtual currency transactions for those who hold virtual currency as a capital asset.

In the 2014 guidance, the IRS applied general principles of tax law to determine that virtual currency is property for federal tax purposes. Notice 2014-21 explained the application of general tax principles to the most common transactions involving virtual currency.

Today, the IRS is aware that some taxpayers with virtual currency transactions may have failed to report income and pay the resulting tax or did not report their transactions properly. Therefore, in July of this year the IRS began mailing educational letters (Letters 6173, 6174, and 6174A) to more than 10,000 taxpayers who may have reported transactions involving virtual currency incorrectly or not at all, to help them understand their tax and filing obligations and how to correct past errors.

Taxpayers who did not report transactions involving virtual currency or who reported them incorrectly may, when appropriate, be liable for tax, penalties and interest. In some cases, taxpayers could be subject to criminal prosecution.

In a nutshell, if you receive more income from the virtual world than you spend, you may be required to report the gain as taxable income.

Bitcoin and similar virtual currencies are classified as property for federal tax purposes and, as such, general rules for property transactions apply.

Among other things, this means that:

• Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
  
  
• Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply. Normally, payers must issue Form 1099.
  
  
• The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  
  
• A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

When you sell virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses.

If you held the virtual currency for one year or less before selling or exchanging the virtual currency, then you will have a short-term capital gain or loss. If you held the virtual currency for more than one year before selling or exchanging it, then you will have a long-term capital gain or loss.

The period during which you held the virtual currency (known as the “holding period”) begins on the day after you acquired the virtual currency and ends on the day you sell or exchange the virtual currency.

Your gain or loss will be the difference between your adjusted basis in the virtual currency and the amount you received in exchange for the virtual currency, which you should report on your Federal income tax return in U.S. dollars.

Your basis (also known as “cost basis”) is the amount you spent to acquire the virtual currency, including fees, commissions and other acquisition costs in U.S. dollars. Your adjusted basis is your basis increased by certain expenditures and decreased by certain deductions or credits in U.S. dollars. For more information on gain or loss from sales or exchanges, see Publication 544, Sales and Other Dispositions of Assets.

The Internal Revenue Code and regulations require taxpayers to maintain records that are sufficient to establish the positions taken on tax returns. You should therefore maintain, for example, records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency.

Even if more regulations are bound to follow, the IRS guidance provides some clarity for taxpayers who want to ensure that they're doing the right thing when utilizing digital currencies.

As always, if you want to do the right thing whenever you have to deal with the IRS, make sure to enroll professional help.