Cryptocurrency- What is “Phantom Income” and why should you be concerned?

Cryptocurrencies represent a novel and exciting way to transact over the internet. With recent surges in the pricing of Bitcoin and other “altcoins” it’s no wonder the user base of cryptocurrencies has soared in the past year. As of March 2021, the largest U.S. based cryptocurrency exchange, Coinbase, reportedly has over 43 million customers. Other companies such as Square and Paypal have made purchasing Bitcoin easier than ever. As a result, the IRS has taken a much deeper interest in “crypto”. The first question on the 2020 form 1040 asks “At any time during 2020, did you receive, sell, send exchange, or otherwise acquire any financial interest in any virtual currency?”. The IRS is making it clear that it expects you to report your cryptocurrency transactions and is intensifying enforcement efforts. It is therefore wise to pay attention to pay attention and avoid unintended tax consequences.

 

Are cryptocurrencies “real” currencies? Not in the eyes of the U.S. government. The IRS classifies cryptocurrencies as property. Any trading of a cryptocurrency constitutes a taxable event. If you are holding your cryptocurrency as an investment, any transaction would trigger a realized capital gain or loss. This is true even if you use one cryptocurrency to purchase another. For instance, if you use appreciated Bitcoin to purchase a quantity of Ether, you have just realized a capital gain in USD, based on the USD value of Bitcoin at the time of purchase. This is so called “phantom income”. You traded your crypto “money” for a different crypto “money”, but really you bartered one piece of property for another. However, a taxable event payable in USD has occurred.

 

Now suppose the Ether you purchased in the example above significantly decreases in value. This could have dire tax implications. If you dispose of the Ether in the same tax year the capital loss could offset the capital gains from your Bitcoin or other assets. What if you dispose of your Ether in a subsequent year for a loss? The capital loss can be used to offset capital gains in the same year or future years, otherwise it would be limited to an annual $3,000 deduction against ordinary income—carried forward indefinitely.  Depending your investment and the percentage of drawdown, you may not be able to afford the tax bill from your original gain on Bitcoin. Keeping track of the cost basis of the various lots of cryptocurrencies you acquire, as well as avoiding using appreciated “lots” of your cryptocurrencies to buy goods or other cryptocurrencies may help you reduce your risk of potential “phantom income” and the associated tax consequences.