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Cryptocurrency Taxation and Blockchain Essentials for 

Accountants Course Introduction Cryptocurrencies, such as Bitcoin, are a new type of digital asset that is becoming more popular everyday. This course will provide an overview of cryptocurrency and the tax reporting and filing requirements that come with it. 

The number of people using cryptocurrency (also called “crypto”) is up to roughly 50 million users worldwide, and the Global Blockchain market size, which was $708 million in 2017, is expected to grow to $60.7 billion by 2024. There has been a 300% increase in jobs related to blockchain and cryptocurrencies since 2017. 90% of American and European banks are now exploring blockchain technology, and international businesses such as IBM, Facebook, Amazon, Walmart, Google, and Goldman Sachs are all investing in cryptocurrency. The IRS began working on creating regulations surrounding cryptocurrency earnings in 2014.  

Tax professionals who complete this course will be prepared to handle clients’ cryptocurrency-related requests; become familiar with the technology, its applications, and the terminology around it; understand and be able to stay current with Federal and State cryptocurrency tax regulations; and be aware of the tools available for crypto-proficient CPAs.  

Learning Objectives Upon completion of this course, tax professionals will 

● Be familiar with blockchain and cryptocurrency technology and its applications for individuals and businesses  

● Understand and utilize critical industry-specific terminology and concepts ● Understand current and upcoming cryptocurrency tax regulations and guidelines ● Be aware of the taxable and nontaxable events related to cryptocurrency activities ● Identify the accounting methods and forms necessary for calculating taxes for 

cryptocurrencies  

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Course Overview Unit 1: Terminology, technology, and applications of blockchain; keys, addresses, and wallets; cryptocurrency transactions; mining; types of cryptocurrency; and exchanges. 

  

Unit 2: Current and upcoming tax guidance, as well as taxable and nontaxable events related to cryptocurrency. The methods and forms used to calculate and file cryptocurrency taxes. 

   

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Unit 1: Cryptocurrency & Blockchain Technology  

Learning Objectives By the end of Unit 1, participants will be able to: 

● Understand and correctly use critical industry-specific terminology necessary to discuss crypto tax filings with clients 

● Define cryptocurrency and distinguish between the different types of cryptocurrency 

● Understand what blockchain is and how it works ● Identify how individuals and businesses use blockchain technology and 

cryptocurrencies 

Unit 1 Overview This unit covers the history of virtual currency and Bitcoin and introduces key concepts about the blockchain: keys and wallets, transactions, miners, types of cryptocurrency, and exchanges. 

Virtual Currencies and Bitcoin  

History of Virtual Currencies Virtual currencies are, simply put, digital money. More accurately, virtual currencies are a digital representation of value that is not issued or guaranteed by a public authority, like a government. Cryptocurrency is a specific type of virtual currency, and most cryptocurrencies are built on something called blockchain technology, to be discussed later. 

Bitcoin is often thought of as the pioneer of digital currency, but there were actually over two decades of development in the field before this revolutionary new technology came about. 

Beginning in 1983, developers attempted to create a digital monetary system that would allow peer-to-peer transactions without needing a single trusted third party, like a bank or company, to verify them. Digital monetary systems gained popularity throughout the 90s and early 2000s. Digicash and B-money were some of the more notable failed digital 

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currencies. These failed virtual currencies helped lay the foundation for Bitcoin but Bitcoin did some important things differently that lead to its success. 

Bitcoin is Born In 2008 a developer, or group of developers, under the pseudonym Satoshi Nakamoto published the Bitcoin whitepaper and introduced the world to Bitcoin. 

In the Bitcoin whitepaper, Nakamoto presented Bitcoin as “a new electronic cash system that uses a peer-to-peer network to prevent double-spending. It’s completely decentralized with no server or central authority.”  

On January 9th, 2009, the first Bitcoins were issued when Nakamoto mined the first block of Bitcoin transactions on the blockchain—the genesis block. This was the start of the bitcoin blockchain network and the birth of a new type of virtual currency: cryptocurrency. 

Bitcoin and Blockchain are not the same thing, though they are sometimes thought of synonymously; Blockchain is the technology, and Bitcoin is a specific type of cryptocurrency that uses that technology.  

Nakamoto’s digital currency network had two features other virtual currencies didn’t that ultimately lead to its international success: 

1. First, Nakamoto’s protocol decentralized the digital ledger. Previous virtual currencies stored and tracked all transactions on centralized ledgers. Centralized ledgers require specific entities to act as trusted authorities in verifying and processing transactions between accounts. Nakamoto resolved this problem by decentralizing Bitcoin’s ledger so that no one entity was responsible for storing and updating records. Bitcoin’s ledger is stored by every computer in the bitcoin network. These computers are known as peers, or nodes. 

2. Second, it incentivized the tracking and verification of transactions. In a process called mining, powerful computers are rewarded Bitcoin for authenticating and maintaining items on the digital ledger. This is how Bitcoin was created, and it was the pattern for the many cryptocurrencies that would follow.  

In summary: 

1. Virtual currencies are any digital currency—money made up of 1s and 0s, stored on a computer somewhere. They don’t require a government or a bank to create or regulate them. 

2. Cryptocurrencies are a specific type of virtual currency. Most cryptocurrencies are built on important decentralized ledger technology called blockchain. 

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3. Bitcoin is a specific type of cryptocurrency created by Satoshi Nakomoto. Bitcoin is the first and still the most popular cryptocurrency today. 

Blockchain  A blockchain is a decentralized digital ledger that records and tracks all accounts and transactions that use its peer-to-peer network. This public digital ledger is shared with all the computers in the blockchain network. The thousands of computers that store and update the blockchain information are known as nodes. There are numerous and varied blockchains; though this course will focus on Bitcoin’s blockchain as the standard to explain the technology, keep in mind that there are exceptions to nearly every rule. 

There are two different categories of blockchain: public and private. The essential difference between the two is who is allowed to add or edit data on that blockchain or onto that ledger. 

A private blockchain is permissioned. Like a building that has restricted access, permissioned networks have restrictions on who is allowed to participate within the network and in which transactions. 

A public blockchain is permissionless. Anyone can join a public blockchain and read, write, or participate within that blockchain.  

Public blockchains are decentralized and secure. No single person or entity has control over the network. While the idea of information being distributed and stored publicly may seem antithetical to security, in the context of blockchain public distribution of the ledger information is actually what makes this form of storing and tracking transactions so secure. 

Most cryptocurrencies are public. It’s part of the appeal. 

There are three main advantages to blockchain: the technology is immutable, the network is decentralized, and the system is trustless. 

Immutability Transactions on the blockchain are immutable. This means that transactions already on the blockchain cannot be changed, and new transactions can only be added to the blockchain with the consensus of the participants on that blockchain. Not only does this keep transaction histories transparent, it increases security and creates an accurate audit trail. 

 

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Decentralization The blockchain is decentralized: each computer in the blockchain network, called a node, keeps a partial or complete copy of the entire blockchain. In the case of Bitcoin, this means that there are hundreds of thousands of copies of the blockchain around the globe. Each node syncs with the network to ensure that its copy of the blockchain ledger is current and verified with the rest of the blockchain. Having that many copies spread across a network of computers makes the data very difficult to alter successfully: there isn’t a single, definitive file or database to manipulate.  

If hackers were to mess with the blockchain, they would need to pause all activities in the network and then break into and change every copy of the blockchain on every node in the network. Even then, they still couldn’t affect the thousands of copies stored offline in cold wallets. 

If someone were to either change a block or receive a block that has been changed, all the nodes in the network would check their copies of the block. And because the ledger is a democratic system, the network compares blocks and votes to keep whichever version of the block has the consensus for accuracy. This is why a distributed ledger is so beneficial: gaining a majority vote is extremely difficult because it requires the possession or takeover and rewriting of over 51% of all devices within the network. 

Trustless The blockchain is called a trustless system. “Trustless” does not mean the system is unreliable or untrustworthy. Trustless actually means the individuals who use blockchain don’t need third-parties to guarantee their transactions.  

When both parties aren’t physically present during a transaction, how can they verify that the property and money are authentic and have been transferred? Typically, a “trusted” third-party, like a bank or a credit card company, acts as an intermediary to guarantee the transfer and authenticity of the transaction. But not everyone has access to banks or credit cards, and sometimes these third party intermediaries aren’t actually trustworthy. With blockchain, intermediaries have been eliminated so there is no need to worry about misplaced trust in any one organization, bank, or government. The math—the data on the blockchain— provides the guarantee of authenticity, not individuals or institutions. The technology’s protocols verify all account balances and transactions, and because the ledger is distributed, the entire network can see and validate the authenticity of every transfer.  

The blockchain is not without fault, however. Because blockchain technology relies on a large, widely distributed network of nodes to maintain security, smaller blockchains with smaller networks tend to be more susceptible to attack. If more than half of the computers working as nodes within the network “tell a lie” by perpetuating inaccurate information, the 

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lie will be accepted as truth. This is called a “51% attack.” Computers on the bitcoin network are monitored closely by the community to ensure no one gains such network influence.  

Blockchain technology can be used to transfer any information, not just cryptocurrencies. It can be used to track or transfer information such as land titles, contracts, and supply chains. Because of this, blockchain technology opens up new opportunities for existing companies, startups, and everyday people to interact more efficiently, directly and globally, and it’s being implemented in some very creative ways. 

Bank of America, for example, hopes to use open-source ledgers in conjunction with Ripple’s XRP token to create more efficient financial transactions for consumers and businesses, potentially saving them billions of dollars every year in cross-border payments. 

Walmart is working on a blockchain-based supply chain management system that will both increase security and improve their ability to identify issues involved with food recalls, such as tracing outbreaks more quickly to limit health risks to consumers. 

Computer companies such as IBM are assisting large organizations like these in exploring unique applications of blockchain technology.  

Overall, however, the most common and well-known use of blockchain technology is the creation and exchange of cryptocurrency. 

Cryptocurrency and the Blockchain Cryptocurrency, like Bitcoin, is a type of virtual currency, a digital asset that has no physical form and exists on a blockchain. 

The main feature that distinguishes crypto from other virtual currencies is its use of cryptography. Cryptographic protocols are the rules and strong encryption algorithms utilized to secure any information transferred in transactions recorded on the blockchain.  

There are two attributes that make Bitcoin and other cryptocurrencies valuable:  

1. Decentralization. Because blockchain networks are decentralized, the cryptocurrency built off blockchain networks is also decentralized. This form of currency is governed by the entities creating and using it rather than by governments, banks, or financial intermediaries. Cryptocurrencies are not subject to the interests of a small group of individuals. This means that anyone, anywhere in the world, can own or use cryptocurrency for payments or transactions. 

2. Disinflationary. Cryptocurrencies are also disinflationary. Most cryptocurrencies have a fixed supply. Bitcoin, for example, has been capped at 21 million Bitcoin. Governments and banks don’t have the ability to create inflation or deflation of 

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cryptocurrencies because they can’t alter or control the amount of cryptocurrency that exists. 

In summary: 

1. Blockchain is a digital, decentralized ledger that records and tracks all accounts and transactions that use its network. The ledger is shared with all computers that use its peer-to-peer network.  

2. There are two different types of blockchain: public and private. 

3. There are three main advantages of the blockchain: the technology is immutable, the network is decentralized, and the system is trustless.  

4. While blockchain is usually thought of as a means to trade cryptocurrency, the technology can be used to transfer any information between parties. 

Keys and Wallets Exchanging cryptocurrency on the blockchain requires an address and a set of public and private keys. This information is stored in a secure location, known as a cryptocurrency wallet. Cryptocurrency is stored on the blockchain under an account’s address, and is retrieved with the account’s private key. 

Private Keys  A private key is a long string of alphanumeric characters that can look something like this: E9873D79C6D87DC0FB6A5778633389213303DA61F20BD67FC233AA33262. 

Private keys do two things. First, they act as proof of ownership of an address and all the funds in it. Second, private keys give the owner access to their cryptocurrency. Each transaction on the blockchain is “signed” with a private key, and only the person who has that private key can access the funds associated with that signature. A private key should never be shared, since sharing a private key is de facto granting access to the cryptocurrency associated with the private key. Conversely, if a private key is lost, there is no way to access the cryptocurrency associated with it. 

In some ways a private key is like a signature, in other ways it’s like a password. The essential point is that the private key grants access to the contents of a specific cryptocurrency address. 

Seed Phrases Companies recognize that private keys can be confusing, so many wallets have begun creating a more user-friendly password. These wallets algorithmically convert a unique 

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private key into a series of words known as a seed phrase or recovery phrase. For example, the private key “12398432834987298347” might be converted to a seed phrase such as “smart from whether north walk sleeve glass.“ 

A seed phrase stores all the information needed to recover access to the wallet, just like a private key. Since a seed phrase can be used to access and transfer cryptocurrency, it should be treated just like a private key: stored in a safe place and never shared with anyone. 

Public Keys and Addresses Public keys and public addresses are algorithmically generated based off of the private key. 

Public keys are used by the blockchain network to identify and confirm a private key and to verify transactions. For many blockchains, a public address is a value generated from the public key for the associated wallet, and is used as the virtual address where cryptocurrency is sent to or from. 

A public address is associated with a balance and is used for transacting on a blockchain network. Public addresses look something like this:  

1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2 

All addresses are publicly visible on the ledger, but by default no identifying information is associated with any individual owner’s address on the blockchain. When a recipient provides their public address to a sender, there is no risk of compromising the private key or wallet associated with that public address; however, the sender does then know that the recipient owns that specific public address. For some people, the anonymity of the blockchain is part of the appeal of cryptocurrency. 

Some wallets generate only one public address for sending and receiving crypto. Other types of wallet may have an extended public key, which can be used to create many public addresses. 

Extended Public Keys Some wallets have a unique feature called an extended public key. An extended public key, also called an xPub, can generate unlimited public addresses linked back to one account.  

Creating new addresses for every transaction helps prevent others from tracking the total amount of cryptocurrency an individual owns. For wallets with extended public keys, wallet owners can generate a new address and put the exact amount of crypto into the address that will be used in a specific transaction.  

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Generating a new address for each transaction is just another layer of privacy that some people value. It also greatly reduces the impact of being hacked. If a one-time-use address does get hacked, it will typically be empty because the majority of the wallet’s funds will be safely stored elsewhere. 

One-Way Math 

The math used to create private and public keys and public addresses is “one way.” The algorithm can always regenerate a public key or address from a private key, even if the public key or address is lost; however, the algorithm can never use a public key or address to deduce the private key. The math does not work backwards; it only works one way. This is why private keys must be kept secure; this is the purpose that cryptocurrency wallets serve. 

Wallets Since Cryptocurrency is stored and secured on the blockchain, it is only the means of accessing that cryptocurrency that needs to be safeguarded. If a private key is irretrievably lost, then the cryptocurrency associated with it is essentially gone, since there is no way to retrieve it; similarly, possessing the private key is essentially equal to owning it, as this allows it to be accessed. Cryptocurrency wallets are simply devices or pieces of software that store public and private keys, with different benefits and shortcomings depending on the type of wallet. 

Some wallets have certain constraints or specifications, such as requiring approval from multiple parties to process transactions or being able to hold only specific types of cryptocurrencies. But all wallets fall into one of two categories: hot storage wallets or cold storage wallets.  

Hot wallets are connected to the internet and cold wallets store your keys offline. There are benefits and shortcomings to each type of wallet, chiefly related to how frequently the user wishes to access their cryptocurrency. For example, users who buy crypto as a long-term investment won’t need to move it very often, but day-traders will want to be able to quickly and easily move their coins many times per day. It’s not uncommon for cryptocurrency owners to have a variety of both hot and cold wallets. 

A hot wallet is the cryptocurrency equivalent of a physical wallet. It is easy to access for frequent cash transactions, but is not as secure as a cold wallet.  A cold wallet, on the other hand, is like storing money in a safe. It is extremely secure, but impractical for day-to-day use. 

Cold Storage Wallets Cold storage wallets store cryptocurrency keys offline. In its simplest form, a cold wallet is simply a physical record of keys and public addresses, whether written on a piece of paper, 

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engraved on a thin piece of metal, stored on a thumb drive or saved on a laptop. As long as the material or device isn’t connected to the internet, it is a cold wallet. This keeps the information, and the crypto linked to it, safe from hackers and viruses. 

Some cold wallets may briefly connect to the internet to transfer funds, but the general rule is that they are kept offline.  

In addition to cryptocurrency balances, some cold wallets store a copy of the entire blockchain history up to the most recent transaction of that cold wallet. This allows the entire history and origin of all the cryptocurrency in the wallet to be traced, thus proving the validity of the wallet’s contents and adding an additional layer of security. 

Cold wallets can be either hardware wallets or paper wallets. An extensive list of cold wallets can be found in the Resources section of this manual. 

A hardware wallet can be any type of physical electronic device, like a USB drive or laptop, used solely for storing cryptocurrency keys. An older laptop or cell phone with a wiped hard drive can be an effective cold hardware wallet. It is important to wipe the hard drive of an older device and install a fresh operating system in order to avoid the risk of viruses or malware from the device’s previous life to compromise the wallet.  

Hardware wallets also include dedicated, high-tech solutions such as USB or Bluetooth devices made specifically for storing crypto. 

The two most popular cold hardware wallets are Trezor and Ledger. Other cold hardware wallets are Bitcoin Core, Armory, and Electrum. 

Before hardware wallets, paper wallets were the de facto standard for cold storage of cryptocurrency keys. As the name suggests, paper wallets were originally made out of paper, but they can also be made of plastic, metal, or any other printable material. Paper wallets are more vulnerable to individual carelessness but are the most hacker-proof crypto wallets. 

Pros of Cold Wallets 

● Safe from hackers and viruses. Since a cold wallet isn’t connected to the internet, it’s safe from virtual theft by online hackers or viruses. Because they’re so safe, they make an excellent option for storing large amounts of crypto for long periods of time. 

● Can be used offline. Physically handing someone a cold wallet with cryptocurrency in it is the simplest and most straightforward way of transferring crypto. As an example, at a recent cryptocurrency convention, USB drives with specific denominations of Bitcoin on them were given away as prizes.  

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Cons of Cold Wallets 

● Less convenient than hot wallets. Because they are not directly connected to the internet, it’s difficult to use the crypto stored in a cold wallet for frequent transactions. 

● More complicated and less beginner-friendly than hot wallets. Cold wallets may require additional steps for initiating and completing transactions, such as manually entering private keys or seed phrases. 

● Vulnerable to human error or theft. Cold wallets are vulnerable to human error and theft, especially when the keys and seed phrases aren’t backed-up in multiple locations. If the critical information stored in a cold wallet is lost or damaged, then the means of accessing the cryptocurrency will be lost forever. 

● Cold wallets may have costs. Aside from paper wallets, there is usually a cost associated with cold wallets. The USB drive, laptop, or engraved metal will have a cost. 

Hot Storage Wallets  

Hot wallets are cryptocurrency storage solutions that run on internet-connected devices. Hot wallets typically provide a wide variety of features and prioritize easy access and security differently.  

Software wallets must be downloaded and installed to run on a single device. They include mobile wallets for smartphones, desktop computer wallets, and browser-based plug-in extension wallets. 

Online wallets are wallets accessible from multiple devices via your web browser. These don’t require downloading software because the wallet is stored on the website. The user sets up an account on the website with a username and password and accesses the wallet by logging in. 

Exchange-based wallets are wallets that exist within an exchange, a website where crypto is publicly traded. Exchanges such as Coinbase and Kraken automatically generate and store private keys within their own infrastructure and then facilitate trading between accounts. The software takes care of signing transactions with the private keys. 

The most popular examples of software wallets include Exodus, Jaxx, and Electrum. Some examples of mobile wallets included Coinomi and Abra. Two of the most popular web wallets are MyCrypto wallet and MyEtherWallet. Examples of exchanges include Coinbase, Gemini, Bittrex, Bakkt, and Kraken. 

A more comprehensive list of hot wallets is provided in the Resources section of this manual. 

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Pros of Hot Wallets: 

● Quick and easy access to funds. Likely the biggest advantage of a hot wallet is how easy it makes performing basic transactions. Individuals looking to make purchases with their cryptocurrency assets might choose to use a hot wallet because the holdings in that wallet are easy to spend and easy to transfer. 

● Support of various devices. A web-based wallet can be accessed by any device with a web browser and the internet, including phone, computer, or tablet. 

● Simple and user-friendly. Many hot wallets securely store keys, replacing the need to keep track of long strings of characters or words in keys and seed phrases with beginner-friendly usernames and passwords.  

● Typically free to set up. Most hot wallet services have free accounts. 

Cons to Hot Wallets: 

● Less control. Many hot wallets, like those provided by the exchanges, restrict access to private keys and cannot function independently from the service, and the user technically never has full control of their funds. The importance of being the exclusive holder of their keys is summed up in a well-known saying in the crypto world: “Not your keys, not your crypto.”  

● Internet required. This might not be a concern for most people, but for those who know that they may need to make immediate or direct transfers without logging into an account or exchange first, this is something to consider.  

● Vulnerable to hacks and cybercrime. As with any software or device that connects to the internet, hot wallets run the risk of being targeted by malware, viruses, or hackers. These vulnerabilities are similar to the risks of any online bank account. In all reality, the biggest risks to any hot wallet’s security are human error and carelessness.  

Main Takeaways for Wallets There are advantages and disadvantages of each type of wallet depending on the needs of the user, with different priorities for ease-of-use or security. Hot wallets have a greater risk of being hacked, but provide the easiest and fastest access to funds. A cold wallet is by far the most secure from cyber attacks, but it takes time and extra steps to access crypto in a cold wallet. All wallets are susceptible to human error.  

A practical approach to wallets: cryptocurrency should be stored in hot wallets only when needed for immediate use. Otherwise, crypto should be stored in a cold hardware or paper wallet and kept somewhere safe. Private keys and login credentials should never be shared. 

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Transactions  Blockchain technology enables the movement of assets or information from one party to another through transactions. A transaction is initiated from an address, signed with private keys, broadcast to the network, confirmed by miners, and then added to the blockchain. The blockchain network ensures that every peer has a record of the complete history of all transactions and thus the balance of every account.  

What exactly is a transaction? On the blockchain, a transaction is a record of three things: the addresses of both the sender and the receiver (the “Who”), the item or items being transferred, (the “What”), and the time the transfer occurred (the “When”). 

The blockchain itself is a huge list of transactions. Blockchain transactions can be the transfer of pretty much anything between two addresses, though the most common example is an exchange of cryptocurrency.  

Transactions can be initiated and recorded directly on the blockchain or they can occur within wallets or exchanges. In regards to cryptocurrency, there are a few different types of transactions that can occur, which are pretty similar to transactions that can occur with other assets. Different wallets or exchanges may call them different things but there are six basic types of transactions that are important to distinguish for tax purposes: buy, sell, receive, send, transfer, and trade.  

Buying is purchasing crypto with FIAT, a government-issued and back currency, or any other asset.  

Selling is getting rid of crypto assets.  

Receiving, sometimes called depositing, is being paid with or given cryptocurrency.  

Sending, or spending, is paying for something using crypto.  

Transferring is when a user is moving crypto from one account or wallet that they own to another that they own.  

Trading is exchanging one form of crypto for another. 

There are three important pieces of information stored in each transaction: 

● The Who part of the file includes the addresses of the sender and the receiver. Addresses or accounts don’t contain any personally identifiable information--it’s sort of like the routing number of a checking account, or a username. 

● The What is the type and quantity of cryptocurrency being transferred between addresses.  

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● The When is the timestamp of the transaction, or the time that the trade actually takes place. The “when” of a transaction is just as important as the who and the what because it determines the order that crypto is spent and prevents users from double-spending their crypto.  

There are two timestamps given to each transaction. The first occurs when the sender inputs their private key and the transaction goes live to the network. Miners who verify transactions use this timestamp to order the sequence of transactions.  

The second timestamp is the moment a transaction is successfully verified by a miner. This is usually the timestamp that users will see on their account: the time and date when a transaction was approved and finalized. 

Unlike accounting systems that record transactions in a central ledger and post them to individual accounts, blockchain technology requires validation of each transaction by the network before it is publicly posted to the distributed ledger. 

The process of validation, called mining, is done by computer devices and begins with bundling transactions into large groups called blocks.  

Once verified by miners, a new block is permanently timestamped and digitally encrypted. New blocks are linked to preceding blocks of data on the blockchain. Each new approved block becomes a permanent part of the blockchain and is added to every peer’s record of the ledger.  

A verified transaction becomes an irreversible and immutable part of the blockchain. Once recorded on the blockchain, the data in any given block cannot be altered retroactively without breaking the chain and altering all the subsequent blocks. Since the ledger is stored with all the network peers, even if an individual were able to alter a verified block, it would not change the other hundreds of thousands of copies of the original block stored on the network, and the individual’s own copy would be rendered invalid. This is a big part of why blockchain technology is so secure. 

Main Takeaways for Transactions The blockchain is a huge list of transactions. Those transactions can be the transfer of pretty much anything between multiple parties. The exchange of cryptocurrency is one example of the type of transactions that occur on a blockchain.  

A cryptocurrency transaction is an entry on the blockchain that specifies three pieces of information: the who (the addresses involved), the what (the type and amount of cryptocurrency), and the when (the time the transfer occurred). After being signed with private keys, a transaction is broadcast to the entire network of peers, bundled into large groups called blocks, confirmed by miners, and then added to the blockchain. 

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Miners In cryptocurrency, the term “miners” can refer to either the computing devices or the owners of those devices that confirm and validate transactions that are added to the blockchain. However, it’s the automated computers, not people, that actually do the work of validation. 

Before a block can be added to the blockchain, an independent third party known as a miner must validate the details of every transaction included in that block by solving a difficult mathematical equation. The first miner to solve the problem gets awarded cryptocurrency and adds the new block of transactions onto the blockchain. For Bitcoin, new blocks are mined about once every 10 minutes. 

Miners are the computing devices that add new blocks of transactions to the blockchain ledger through the validation process known as mining. Nodes are the computers that store the ledger in the blockchain’s peer-to-peer network. Every node stores a record of the history of transactions and thus the balance of every account on the blockchain, but the extent of the history that a node stores depends on the type of node. For example, a light-weight node stores a partial copy of the blockchain, such as transactions from the past 30 days, but a complete node stores a copy of the entire transaction history dating back to the blockchain’s genesis block—the first ever mined block on the chain. Nodes automatically sync with the network to ensure their copy is accurate and up-to-date as new data is generated.  

Verifying Transactions So, miners are the computing devices that do the work of mining, and mining is the process of verifying and adding transactions to the blockchain ledger. The term mining is synonymous with validating, and those terms are used interchangeably in this course. 

There are three main phases of verifying a transaction. First, a miner confirms that the amount of crypto is present in the sender’s account and was not double-spent. Second, transactions are bundled into blocks and a miner solves a very complicated math equation specific to that block. And finally, when a correct solution is found, it is broadcast to the network to be verified as valid by other miners and then added to the blockchain. 

Proof of Work The majority of blockchains use a method known as “proof of work” to validate transactions. 

First, miners select pending transactions to verify and bundle into large groups, called blocks. For bitcoin blockchain, blocks can hold information for about 3000 transactions. 

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Next, in order for this new block to be added to the blockchain and have all other miners register it in the public ledger, it needs a signature from the miner who created the block. This is the proof that the programmatic work has been done. The signature is created by solving a complex puzzle using an algorithm, called a hash function, to generate a number that identifies the new block of transactions. This number is called the block hash. Because each block has a different hash, or problem to solve, every miner works on a problem that is unique to the block that they build. These problems are very difficult to solve, but the solutions can be quickly verified. 

Finally, once a miner finds a correct solution to a new block, they broadcast that block and its hash to the network to be confirmed as valid by the other peers and accepted to the blockchain. All the transactions within a block are verified once the block is added to the blockchain. 

Every piece of information in every transaction in a block contributes to the block’s hash, so if even one detail of one transaction is changed, the resulting hash for the entire block will be changed too. The hash of the parent block, the block immediately preceding the new block, is also used in computing block hashes. This makes it very easy to identify attempts to modify accepted blocks because changes to any transaction in a block will not only change the final block hash but all the blocks following it as well. 

Mining Devices Solving these math problems requires a lot of computing power. That takes dedicated computing devices with extremely fast processors. Because of this, miners are always looking for the fastest and most efficient hardware to reduce time and energy costs, and increase their chances of winning a block. 

Additionally, mining devices require more electricity and generate more heat than typical computers. This means that miners usually have multiple dedicated computers at mining sites along with necessary cooling equipment. That much space and power is expensive. 

Mining Rewards The incentive for miners to validate transactions is transaction fees and cryptocurrency. 

When a miner wins a block, they are given a block reward, which is cryptocurrency. For the bitcoin blockchain in 2019, the block reward was 12.5 Bitcoins. This cryptocurrency is the miner’s to spend, convert to US dollars, or just hang on to as an investment.  

Miners are also paid a small fee for every transaction in a block they verify. These fees are nominal and determined by the blockchain, wallet, or exchange. They’re usually paid by the sender of the crypto in the transaction.  

As cryptocurrency becomes more popular and the trading of crypto more commonplace, the number of transactions available to be mined at any one time increases, thus 

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increasing opportunities for miners to validate transactions and win block rewards and transaction fees. Unfortunately, an increase in competition has also made it statistically less likely that any one miner will win a block. This is why many miners participate in something called a mining pool. 

Mining Pools Mining pools are groups of computers that share their processing power over a network. By pooling resources, miners increase their chances of being the first to mine or “win” a new block. 

When any member of a mining pool is the first to win a block, all participating members of that pool will share in the reward. This decreases the individual payout for winning a block, but since only the fastest and most accurate miner gets the mining reward, participating in mining pools increases the odds for miners of winning and getting a portion of the reward. Additionally, miners can choose to mitigate costs associated with mining by splitting expenses related to housing, running and cooling their computers with other miners in their pool. 

Main Takeaways for Mining Miners are the computing devices (or the owners of those devices) that validate transactions and add blocks, or large groups of transactions bundled together, to the blockchain. Mining involves solving a complex math problem for each block. The first miner to solve the problem and win the block gets a reward. Whoever wins the block receives a cryptocurrency reward and the transaction fees. Miners can combine their processing power by joining mining pools and increase their chances of winning a block. 

Cryptocurrency To summarize, blockchains, like the bitcoin blockchain, are decentralized digital ledgers that track the transfer of information between accounts. Transactions are collected into large groups of data called blocks. Miners are the computing devices that verify and add blocks of transactions to the blockchain. The first miner to verify a block is rewarded with cryptocurrency. Like other financial assets, this reward holds value on the open market. 

Cryptocurrencies are digital assets that have no physical form and exist on a blockchain network. Cryptocurrency is usually minted when miners verify transactions on the blockchain, but there are a few exceptions, such as when it’s created in a genesis block or issued in an initial coin offering. In general, though, most existing cryptocurrency was minted by a miner. 

Cryptocurrencies have value due to a few factors. Their decentralized and disinflationary nature creates value because no single actor controls crypto or its supply. Anyone can own 

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or use it, and governments and banks can’t cause inflation or deflation of the currency by altering its supply. 

As with all things, the value of crypto is affected by supply and demand. Most cryptocurrencies have a predetermined supply limit. For example, Bitcoin is capped at 21 million. As of 2019, around 17.3 million Bitcoins have been mined and are in circulation. It’s estimated that the last Bitcoin will be mined in 2140. This means that the amount available to be mined decreases with each passing year. Additionally, the demand for cryptocurrency has also increased dramatically over the past decade. 

Cryptocurrency was originally created along with the blockchain to be used as payment for miners confirming transactions, but it later led to an incredibly dynamic, fast-growing market for investors and speculators. Since Bitcoin was born, over 4000 new cryptocurrencies have been created. These various cryptocurrencies have some important distinctions and differences. 

There are three major categories of cryptocurrencies: coins, altcoins, and tokens. 

Coins Coins are cryptocurrencies that are native to their own blockchain. Two examples of crypto coins are Bitcoin and Ether. Bitcoin exists and operates on the bitcoin blockchain; Ether operates on the ethereum blockchain. Coins have unique coding protocols and thus use different methods for encrypting or verifying data. Coins can be thought of as barter currency: they exist for the purpose of making and receiving payments on their blockchain. 

Bitcoin Bitcoin was the first internationally successful decentralized cryptocurrency to be created and, as indicated by the name, is a crypto coin. Bitcoin serves as the digital gold standard in the cryptocurrency industry. It is the largest and most well-known cryptocurrency around the globe, with over 300,000 transactions every day.  

In 2009, 1 Bitcoin (BTC) was worth .0001 cent. In 2012, 1 BTC reached $100. And at its peak, around the end of 2017, it was worth almost $20,000. As of early 2020, 1 BTC is valued around $1000. 

Like many new financial assets, the price of Bitcoin has drastically fluctuated over the past decade as its technology and usefulness is explored, tested, and expanded. Despite its volatility, Bitcoin’s overall trend is upward, and it is projected to be a reliable medium of exchange and store of value in the years to come. After Bitcoin’s international success, thousands of new cryptocurrencies have been launched.  

As more and more people began interacting with and accepting Bitcoin, ways to improve or change features of Bitcoin’s blockchain technology began to emerge. This is how altcoins, 

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or alternative-coins, originated. Developers began creating thousands of new blockchains and cryptocurrencies with either modified or completely new rules and methods for encrypting, processing, and storing information.  

Altcoins Modifications or updates to the protocol or rules of an existing blockchain network’s technology can result in the creation of a new cryptocurrency. These kinds of cryptocurrencies are known as altcoins, and a change to an existing blockchain’s technology is known as a fork. 

The term altcoin is sometimes used to refer to any crypto coin that isn’t Bitcoin. However, in the crypto world, altcoins are more commonly defined as any coins derived or forked from a blockchain’s primary or main line coin. 

Different types of forks can have different impacts on a blockchain and its cryptocurrency, as well as different tax implications. 

Forks Just like a fork in the road, forks in a blockchain create a change or divergence in the once singular path of an existing distributed ledger, either altering the original path or creating a completely new alternative route.  

Forks are created through changes to the software of an existing blockchain system. Forks occur when small improvements or updates to the software need to be made or when major changes are introduced in order to offer new features or services to users. 

Forks can be “soft” or “hard.” Both types modify an existing blockchain but soft fork changes are compatible with the previous code while hard forks are not. Some hard forks can result in the creation of a new cryptocurrency. New cryptocurrency created after a hard fork is stored and traded on the new, modified version of the blockchain. 

Soft Forks A soft fork is any minor change or update to a blockchain’s code that doesn’t conflict with previous versions of the blockchain and is thus backward compatible. This means that old blocks mined with the previous protocols are still recognized as valid by the new software. This also means nodes using previous versions can still mine new blocks and can choose whether or not they want to update to the new software protocols. Examples of soft forks are changes in terminology or how accounts are encrypted.  

Soft forks don’t alter the value of the coins associated with that blockchain.  

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Hard Forks A hard fork is a major change in a blockchain’s protocol rules such that the new protocol is not backward compatible with the previous legacy protocol. Compatibility is essential for nodes to be able to sync with the network and keep the blockchain secure and accurate. Because of the incompatibility between the old and new code, everyone in the network needs to agree to a planned hard fork and update to the new version.  

Sometimes, not everyone in the network agrees that the updates or changes in the code should be made. In these situations, if a consensus can’t be reached, the network can choose to split and run the old and new protocols on separate blockchains. These kinds of controversial hard forks can sometimes create a new cryptocurrency, an altcoin, which will be stored and recorded on the new blockchain. 

Not all hard forks create altcoins but when they do, a few things can occur with owners of the original crypto and their investments. Owners can be offered equal quantities of the mainline coin and its new altcoin and the network will electronically dispense, or airdrop, the new crypto into participating accounts in the blockchain. They may be given the choice to transfer some or all of their original investment to new altcoin and retain both types. Or owners may only be allowed to retain one type and investors must choose to either keep their investment in the mainline coin or transfer to the new crypto.  

One example of a controversial hard fork in the bitcoin blockchain created the first altcoin to Bitcoin: Bitcoin Cash. 

As Bitcoin gained mainstream popularity, scalability issues of the blockchain were revealed as new transactions flooded the network faster than they could be processed. Bitcoin became increasingly hard to mine and transactions required more and more hardware to validate. To address this, some of the group running the network thought the network protocol should be changed to reduce the hardware requirements for mining new blocks. Since only part of the network wanted to implement these changes, a hard fork in the bitcoin blockchain occurred. Each Bitcoin owner received an equivalent amount of Bitcoin Cash after this hard fork.  

Tokens Unlike coins that hold value as a medium of exchange, tokens have real world value in that they represent a specific, tangible asset or utility. Tokens are created on existing blockchains. 

There are two broad types of tokens. Security tokens can represent stakes in stocks, assets, or other types of cryptocurrency. Utility tokens give ownership or access to a specific service. 

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A security token might indicate shared ownership of a piece of land or a work of art or a business. Utility tokens, on the other hand, give access to a specific company’s current or future services. In some cases, they are like credits in an online gaming account that can be used to access different equipment. When the utility token is for a future service, purchasers pay the issuer now so that the issuer can build a product or feature that the purchaser will later get access to. A game company might develop additional levels in their game that token owners will have access to when it’s complete. Obviously there are risks associated with paying for theoretical future services that don’t yet exist. 

Besides the base value of the asset or utility, a token can also give the owner additional rights that relate to the asset. For instance, a tech company’s token might include the right to vote for which new software the company develops. Other tokens give owners the ability to access certain features that other users do not have, similar to the benefits of a premium account for members instead of the free version for guests. 

Ethereum is the most well-known, utility token system. The majority of crypto-based startups created within the past five years have been software applications that run off of the Ethereum network. These are known as ERC-20 apps. And tokens built off of the Ethereum network, or ERC-20 tokens, represent the vast majority of new tokens. 

Ethereum is a blockchain that runs smart contracts. A smart contract contains the rules and regulations for negotiating the terms of a contract. A smart contract can be written for anything: selling a company, building a house, or even planning a wedding. When the platform verifies that the conditions of the contract are met, the contract automatically executes. But executing these contracts requires a lot of computing power, so the number of contracts that can run on the Ethereum network is limited to the amount of computing power that’s available. How processing power is allocated is determined by the payment of tokens, so running an app on the Ethereum network requires buying their tokens. 

The vast majority of people who buy and sell tokens are investors involved in speculation using easy-to-access global exchanges. While they are typically hopeful that upward momentum will fund the continued development of a service they believe has value, utility tokens are similar enough to stocks that the SEC took a good look at them to determine if they are securities. Their regulation addressed how utility tokens are dealt with and a distinction between ICOs and STOs. 

ICOs In order to raise capital necessary for development and expansion, a company can create and offer a new cryptocurrency coin or token to investors. ICOs, or Initial Coin Offerings, are the cryptocurrency equivalent of an IPO, or Initial Public Offering, but cryptocurrency is offered in the place of shares. In spite of their name, ICOs are overwhelmingly token-based, and most of the token-based ICOs are ERC-20 apps built on the Ethereum network. 

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Any company can create a new cryptocurrency and offer it to public investors to raise capital. However, coin owners are not offered any ownership of or voting rights in the business. Investors buy into ICOs hoping that the new crypto will be successful and that they’ll see a big return on their investment. ICOs are unregulated by governments and, for United States tax purposes, treated like a security. 

ICOs allow startups and other companies to bypass the somewhat rigorous and time-consuming process of raising funds through more regulated means. Limited regulation is beneficial in terms of company growth—an attribute particularly important in the aggressive and fast-moving tech industry—but it also creates an opportunity for fraud. The lack of regulation around creating ICOs has led to fraudulent companies and bogus investment opportunities. Ultimately this has brought about an increase in education and discernment among cryptocurrency investors and an increase of companies creating STOs instead of ICOs. 

STOs An STO, or Security Token Offering, is an offering similar to an ICO, but it differs in that STOs are regulated by the governments in which they operate whereas ICOs are not. Like ICOs, STOs can be offered in the form of crypto coins or tokens.  

In order for a company to initiate a Security Token Offering, they have to declare what their services or products will do and get government approval. Once an STO has been approved, accredited investors can invest. In the United States, Security Token Offerings are very similar to Series A Public Offerings. This government oversight was, in part, a response to the frequent volatility and fraud associated with ICOs. 

Whether a company offers an STO or an ICO will depend not only on whether their service or product complies with the SEC’s regulations, but also on its size, funding, and deadlines. The process of offering an STO involves more steps, takes more time, and requires more overhead than an ICO. Consequently, companies offering STOs tend to require more money in the initial startup phase, long before the company can initiate a public offering. This can be a legitimate reason for initiating an ICO, particularly for small or underfunded companies. 

Every country has its own rules and regulations regarding STOs. This means that the process can take even more time and money to complete if the STO is offered internationally because it must be completed and approved for each country in which it is distributed. Fortunately, as multinational STOs are becoming more popular, new guidance has been created recently to streamline the process of complying with regulations across borders, benefiting companies and investors alike, regardless of their location. 

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Crypto Wrap-up Cryptocurrency is a digital asset that has no physical form and exists on a blockchain network. Cryptocurrency is minted when miners verify transactions on the blockchain. There are three major types of cryptocurrency: coins, altcoins, and tokens. A coin is any cryptocurrency that exists on its own blockchain. Bitcoin is the most popular and well-known example of a cryptocurrency coin.  

Altcoins are a form of crypto that is created by a hard fork in a blockchain’s technology. A fork is the term used to refer to the occurrence of a permanent change in the rules or protocol of a cryptocurrency blockchain network. Soft forks are compatible with the previous protocol but hard forks are not. Bitcoin Cash is an altcoin that originated from the first hard fork in the bitcoin blockchain. 

Tokens are a type of cryptocurrency that represent a specific tangible asset or utility. The most popular example of a token is Ethereum.  

New companies that use blockchain technology can generate revenue by issuing crypto through either an ICO or an STO. ICOs are similar to IPOs, but the new company issues crypto to their investors rather than shares. STOs are regulated by governments. 

Exchanges Exchanges are becoming an increasingly popular method for individuals to quickly and easily purchase and trade cryptocurrencies. Because of this, investors that diversify their portfolios by investing and trading in cryptocurrency will have filings related to crypto exchanges. It’s important for tax professionals to not only have a basic understanding of what exchanges are and the services they provide, but to also be familiar with some of the big names in the world of exchanges.  

Cryptocurrency exchanges are online platforms where cryptocurrencies are publicly traded. Crypto exchanges automatically generate and store private and public keys and addresses for their accounts within their own infrastructure, and then allow accounts to trade with one another. 

Some big names in crypto exchanges are Coinbase, Gemini, Bittrex, Bakkt, and Kraken. Each exchange presents advantages and drawbacks, and all are regulated by governments to a different extent. There are general pros and cons of exchanges as compared to other means of exchanging and storing crypto, but the specifics of each exchange differ, and should be thoroughly researched before use. 

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Advantages of Exchanges The main advantages of exchanges are their convenience, the speed at which they can process transactions, and their anonymity. 

● All the accounts on an exchange as well as their corresponding keys and cryptocurrency are generated and stored within the exchange’s infrastructure. This makes it really easy to set up an account and get started. It’s also easy to make frequent and convenient trades. 

● Purchases and sales can be processed almost instantly. Most exchanges own a large amount of cryptocurrency and use their own local ledger for processing and recording transactions. Users who trade within an exchange are actually trading crypto owned by the exchange, which is what makes it almost instantaneous. 

Outside of an exchange, transactions that occur directly on the blockchain must be uploaded and verified by miners, a process that can take hours or even days to finalize. Since exchanges can process transactions so quickly, exchange wallets are a much more realistic option for high frequency traders who need to make a lot of trades at a moment’s notice. 

As a side note, the total amount that can be bought or sold on an exchange is usually limited to the total amount of cryptocurrency that the exchange owns.  

● Using exchanges is anonymous. An exchange wallet’s address and its contents are stored on the exchange’s local ledger, not on the blockchain’s public ledger. This means that the transactions that occur within an exchange and the exchange’s accounts and their balances are confidential: no one but the account owner can see the account’s transaction history unless the exchange is hacked or the records are seized. 

Disadvantages of Exchanges There are three main drawbacks of using most exchanges: their centralized structure, fees, and lack of crypto options.  

● Although exchanges are faster and more convenient, they are also less secure. The biggest disadvantage of exchange wallets is their centralized structure. While currencies being traded on these platforms operate on a decentralized ledger, the account information, personal details, keys, and account balances are stored on the exchange’s ledger, which is centralized. This structure creates an appealing target to hackers. Exchanges try to combat this risk by frequently updating and adding security protocols to their systems, but without a blockchain to distribute information and activity across millions of nodes, there is a single point of failure that, if accessed, will compromise the sensitive information and holdings within that 

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exchange wallet. Additionally, if the exchange goes out of business, all the crypto in an exchange wallet is lost.  

A common practice for traders is to store smaller amounts in the exchange wallets, while using a separate cold storage wallet to store the majority of their crypto holdings. 

● When trading cryptocurrency, there are fees associated with each transaction. This is true of any transaction on or off blockchain. But there can be additional costs for transactions on exchanges, and most exchanges also charge fees to withdraw crypto from their platform. 

● Each exchange has a limited number of currencies available for trade. New and exciting projects take time before they are listed on the established exchanges. Although large and popular exchanges like these have the largest amount of coins to trade, they may not have the newest startups listed.  

Exchanges have pros and cons, just as wallets do, and different exchanges will suit different needs. Exchange wallets are usually free to set up, provide the convenience of storing all key information and crypto in one place, and increase the ease and speed of buying and selling crypto. But since exchange wallets keep control of all the accounts and account information on their platform, they are a bigger target for cyber criminals. They may also charge fees to withdraw investments from them. A good rule of thumb is to use an exchange to keep crypto only for frequent trading, and use a secure cold wallet for investment storage. 

Unit 1: Wrap-up Virtual currency is the umbrella term for any digital assets that have no physical form. Cryptocurrencies are a type of virtual currency, and Bitcoin is a specific type of cryptocurrency.  

Blockchain is a digital, decentralized ledger that facilitates the transfer of any information between accounts. The ledger records and tracks all accounts and their transactions, and is shared with all the computers that use its peer-to-peer network. There are three main advantages of blockchain: its immutability, the decentralization of its ledger, and its ability to operate without needing trusted intermediaries. A popular use for blockchain technology is the trading and storage of cryptocurrency, like Bitcoin.  

Exchange cryptocurrency on the blockchain requires an address and keys, stored in a cryptocurrency wallet. Cryptocurrency is stored on the blockchain under an account, called an address. All of an account’s sales, purchases, exchanges, and balances are attached to its public address and recorded on the blockchain. The blockchain ensures that every peer has a record of the complete history of all transactions and balances of every account in 

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the network. A sender needs the recipient’s address to send them crypto, and the recipient uses their private keys to withdraw or send it. Keys are stored in cold wallets or hot wallets, and both types of wallets have distinct advantages and disadvantages depending on how often and how quickly the user wants to access their cryptocurrency. 

The blockchain is a huge list of transactions. A transaction is a data entry on a blockchain and can be the transfer of pretty much anything between multiple parties, such as the exchange of cryptocurrency. A transaction specifies three pieces of information: the “who,” or the addresses involved, the “what,” or the type and amount of cryptocurrency being transferred, and the “when,” or the time the transfer occurred. After being signed with private keys, a transaction is broadcast to the entire network, validated by miners, and then added to the blockchain.  

Miners are the computing devices that validate, or “mine,” blocks of transactions on the blockchain by solving difficult mathematical equations. The first miner to solve the problem “wins the block” and is awarded cryptocurrency when they add the new block to the blockchain. Miners are paid for verifying blocks with cryptocurrency and transactions fees. By participating in mining pools, miners can increase their chances of being the first to win a new block. 

There are three different types of cryptocurrency: coins, altcoins, and tokens. Coins are cryptocurrencies that have their own blockchain platform. Altcoins are cryptocurrencies that are derived or forked from a blockchain’s primary or main line coin. Colloquially, altcoins are often a term that is used to describe any crypto coin that isn’t Bitcoin. A cryptocurrency token is the digital ownership of a specific utility or asset. 

ICOs, or Initial Coin Offerings, are the cryptocurrency equivalent of an IPO and are unregulated. Security Token Offerings (STOs) are similar to ICOs but are regulated and backed by governments. Because of the unreliability of ICOs, STOs are becoming much more common. 

Finally, cryptocurrency exchanges are online platforms where cryptocurrencies are publicly traded. For each account on the exchange, the crypto exchange automatically generates and stores private and public keys and addresses within their own infrastructure. Exchanges are quick, convenient, and anonymous. But exchanges can also have increased hacking risks and fees for withdrawing funds invested with the exchange.  

The United States tax policies and regulations, and the taxable and nontaxable events related to cryptocurrency, will be covered in the next unit. 

 

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Unit 2: Crypto and Taxes 

Learning Objectives By the end of Unit 2, participants will be able to:  

● Understand and apply the following regarding taxation of cryptocurrency and blockchain: 

○ Federal tax regulations: existing and upcoming ○ AICPA suggested regulations ○ Upcoming guidance from the Internal Revenue Service 

● Identify and classify taxable and non-taxable events involved with blockchain and cryptocurrency tax filings and apply the corresponding IRS regulations and guidelines for each event 

● Apply the correct methods and forms when calculating taxes for cryptocurrency ● Recognize the documentation and backup statements necessary for audit 

preparation 

Unit Overview This unit discusses cryptocurrency and taxes, covering federal tax policies, taxable and non-taxable events, and the necessary accounting methods and forms. Existing guidelines, suggested regulations from the AICPA, and the upcoming Internal Revenue Service (IRS) guidance are covered within, as well as tax regulations being drafted by the US government, such as the Token Taxonomy Act. 

A basic understanding of blockchain and cryptocurrency is required to follow the contents within, and was covered in Unit 1.  

In Revenue Ruling 2019-24 from the IRS, virtual currency is defined as “a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency.” Simply put, virtual currencies are digital assets. Cryptocurrency is a specific type of virtual currency and the digital transfer of cryptocurrency is recorded on distributed digital ledgers, known as blockchains. 

“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.” Blockchain is a digital, decentralized ledger. Decentralized means there’s no single authority in charge of the ledger, so the entire community stores and tracks all the accounts and transactions that use its network. Accounts on a blockchain’s ledger are called addresses, and transactions 

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are any transfers between addresses, such as the transfer of cryptocurrency, on the blockchain. 

Cryptocurrencies are digital assets that are recorded and traded on the blockchain.  

Blockchain networks frequently undergo changes in their code. Permanent changes that update or alter the rules of a blockchain are called forks. There are two types of forks: hard forks and soft forks. Changes in a blockchain’s technology that are modifications or updates to the software that doesn't make it invalid with the previous versions are soft forks. Soft forks don’t create new cryptocurrency. Hard forks are changes to protocol that actually diverge from and are incompatible with the original “legacy” code. Hard forks can sometimes create a new cryptocurrency, and they’ll be stored and recorded on the new blockchain. Blockchain networks can distribute this new crypto via an airdrop, which is, very simply, a digital method of distributing crypto to participating accounts.  

So, the main takeaways are: soft forks are small changes still compatible with previous versions of the blockchain’s code and don’t create new crypto. Hard forks are major changes to the network, incompatible with its legacy code. Hard forks sometimes create new crypto, where you end up with two. Networks disperse the new crypto via airdrops.  

The three types of cryptocurrency include coins, altcoins, and tokens.  

 

A coin is any cryptocurrency that exists on its own blockchain; different coins can have different methods for encrypting and verifying information on their blockchain. Bitcoin is the most popular and well-known example of a crypto coin. Altcoin is often used as a colloquial term to describe any crypto coin that isn’t Bitcoin. But in the crypto world, altcoins are more commonly defined as any coins derived or forked from a blockchain’s primary or main line coin. Well-known altcoins are Litecoin and Bitcash. Tokens are a type of cryptocurrency built off of pre-existing blockchain networks and that represent specific assets or utilities. The most popular example of a token is Ethereum and ERC-20 tokens.  

The IRS uses the umbrella terms of virtual currency and cryptocurrency to refer to any of these types of crypto, and they are presently treated the same for tax purposes. 

There are several types of crypto transactions. Cryptocurrency transactions can occur in a variety of ways and it is central to filing crypto taxes to know and distinguish between the different types of transactions. Crypto transactions can occur and be recorded directly on the blockchain or in off-blockchain transactions. They can be between addresses on a blockchain or accounts in an exchange. There are six basic categories to classify transactions: buying, selling, receiving, sending, transferring, and trading. However, exchanges and wallets may use different terminology to label the activity between accounts.  

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Buying is purchasing crypto with FIAT, a government-issued and backed currency, or any other asset. Selling is disposing of crypto assets. Receiving is when being paid with or given cryptocurrency. Sending is using crypto to pay for goods or services or gifting it to another account. Transferring is moving crypto between accounts or wallets owned by the same individual. Trading is exchanging one form of crypto for another.  

Many individuals participating in crypto transactions, even CPAs, are unaware that many of these activities have tax consequences that could result in tax liability. This course provides an overview of these tax issues. 

Federal Tax Policies In Notice 2014-21 and Rev Rule 2019-24, the Internal Revenue Service addresses the taxation of virtual currency transactions, such as Bitcoins or other similar digital assets. On the IRS website, under the frequently asked questions on virtual currency it states that, for United States federal tax purposes, “Virtual currency is treated as property, and general tax principles applicable to property transactions apply to transactions using virtual currency.” 

IRS Notice 2014-21 holds that taxpayers must recognize capital gains or losses on the exchange of cryptocurrency for cash or for other property. Accordingly, gains or losses are recognized every time that cryptocurrency is sold or used to purchase goods or services. How gains or losses are recognized depends largely on the type of transactions conducted and the length of time the position was held. 

There are many events unique to cryptocurrencies that are not addressed in either the IRS Notice 2014-21 or Rev Rule 2019-24. Additional regulations and legislation are being developed and are expected to be released in the next couple of years. In response to the lack of thorough crypto-specific tax guidance, the AICPA published Updated Comments on Notice 2014-21: Virtual Currency Guidance, a letter to the IRS suggesting regulations and guidances that should be created to address the wide variety of cryptocurrency events. This course uses the AICPA’s letter to inform any events that fall outside the IRS Notice 2014-21 or Rev Rule 2019-24, since it’s likely that the IRS will be using those recommendations to create new tax guidance. To ensure clarity, as we cover each type of taxable and nontaxable event, we’ll specify which of those documents is being used to inform our approach. 

There are both taxable and non-taxable events that can occur for individuals who purchase, trade, or accept cryptocurrency, or participate in activities involved in mining cryptocurrency. 

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Non-taxable Events There are several non-taxable events that can occur with virtual currency. These include gifts, transfers, purchasing crypto, soft forks, two specific types of hard forks, and charitable contributions. 

Gifts Giving the gift of cryptocurrency to another individual or entity is a non-taxable event as long as it does not exceed the yearly tax exempt allowance for gifts. 

Gifts are addressed in the “Frequently Asked Questions on Virtual Currency Transactions” Q&A 30-32 on IRS.gov. There are three main concepts discussed in that document: 

● First, gifts of virtual currency are not considered income until they are sold, exchanged, or otherwise disposed of. (IRS FAQ Q&A 30) 

● Second, the recipient of a gift inherits the original cost basis of the virtual currency. Guidelines for calculating the cost basis are outlined in Q&A 31: “Your basis in virtual currency received as a bona fide gift differs depending on whether you will have a gain or a loss when you sell or dispose of it.” To determine a gain, the cost basis equals the donor’s basis plus any gift tax the donor paid on the gift. To determine a loss, the cost basis is equal to the lesser of the donor’s basis or the fair market value of the virtual currency at the time the gift was received. If there is no documentation to substantiate the donor’s basis, the cost basis is zero. 

● Finally, virtual currency gifts have an associated holding period that includes the time the virtual currency was held by the person who gave the gift. If there is no documentation substantiating that person’s holding period, the holding period begins the day after the gift is received. (IRS FAQ Q&A 32) 

Transfers 

Transferring cryptocurrency between addresses or wallets that an individual personally owns is like transferring money from one account to another. There is no actual sale or exchange of currency; assets are simply being moved from one location to another. So, transfers are a non-taxable event. 

Purchasing Crypto When cryptocurrency is purchased with US Dollars or other forms of government-back FIAT, it is considered a nontaxable event. Gains or losses on crypto are not realized until 

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the crypto is traded, used, or sold. How the sale of these purchases will be taxed will be covered in the taxable events section. 

Crypto might also be purchased to be held in an IRA or similar retirement savings account. The lack of guidance on this type of crypto purchase is addressed in the AICPA’s Comment Letter on Notice 2014-21 Virtual Currency: “Taxpayers need guidance on whether other types of retirement accounts, if any, can hold virtual currencies. The IRS should also provide guidance on what special documentation rules or requirements apply given the decentralized nature of virtual currencies and the various ways these currencies are held and transferred.” 

Hopefully, the IRS will be providing this guidance soon. 

Forks Both soft and hard forks are addressed in the most recent guidance from the IRS, Rev Rule 2019-24, and in the “Frequently Asked Questions on Virtual Currency Transactions” on the IRS website. These documents provide guidance for this section. 

The occurrence of a soft or hard fork in any blockchain is not a taxable event. Only when a hard fork creates new cryptocurrency that is distributed to the taxpayer is it taxable. It’s the creation of the currency, not the fork, that incurs taxation.  

Soft forks in a blockchain do not create new cryptocurrency, so crypto investments will be the same before and after a soft fork. Since a soft fork does not result in new crypto or income, they are nontaxable events.  

Hard forks that do not create new crypto are treated the same as soft forks. No new crypto means no new income, so this type of hard fork is also a nontaxable event. 

Some hard forks will create a new cryptocurrency in addition to the original cryptocurrency owned by the taxpayer, but this is only taxable if they receive the new crypto, as stated by the IRS Q&A: “If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop or some other kind of transfer, you don’t have taxable income.” 

So, soft forks are never taxable events and hard forks are taxable only when the taxpayer receives new cryptocurrency as a result of the hard fork. 

Charitable Contributions  The donation of crypto to a charitable organization is treated like any other charitable contribution. The taxpayer does not recognize income, gain, or loss on the donated crypto if the receiving organization qualifies as a charity under Internal Revenue Code Section 

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170(c). Claiming a deduction for any charitable contribution, including crypto, is covered in Publication 526, Charitable Contributions.  

Tax deductions must be calculated for a charitable donation of crypto. If the crypto was held for more than one year, the tax deduction is equal to the fair market value at the time of the donation, and the taxpayer doesn’t recognize any gains. If the donated crypto was held for one year or less, the deduction is either the crypto’s cost basis or its fair market value at the time of donation, whichever is less. 

Taxable events Taxable events involving virtual currencies include: Selling crypto investments, trading crypto for crypto, certain hard forks, mining, receiving crypto as income, one-off transactions, and ICOs and STOs. 

Selling Crypto Investments  Capital gains or losses must be recognized on the sale of virtual currency, subject to any limitations on the deductibility of capital losses. According to IRS Notice 2014-21, the short and long term capital gains or losses on the sale of crypto investments is calculated based on the difference between the original cost basis and the final sale price of the cryptocurrency. Capital gains and losses are also calculated based on the holding period.  

As with calculating any capital gains or losses, if the investor held the virtual currency for one year or less before selling or exchanging it, they will have a short-term capital gain or loss. If the virtual currency was held for more than one year before selling or exchanging it, it will be a long-term capital gain or loss. The period during which the investor held the virtual currency (known as the “holding period”) begins the day after they acquired the virtual currency and ends the day they sell or exchange it. 

When virtual currency is sold for real currency, the gain or loss will be the difference between the adjusted basis in the virtual currency and the amount received in exchange for the virtual currency, which must be reported on Federal income tax returns in U.S. dollars.  

To determine the cost basis in virtual currency purchased with real currency, calculate the amount spent to acquire the virtual currency, including fees, commissions, and other acquisition costs in U.S. dollars. The adjusted basis is the basis increased by certain expenditures and decreased by certain deductions or credits in U.S. dollars. 

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Trading Crypto for Crypto  Trading refers to the exchange of one kind of cryptocurrency for another kind of cryptocurrency. Crypto can be traded using exchanges or directly between addresses in peer-to-peer trades. Trades can be recorded on-chain or off-chain: that is, recorded directly and visible on a blockchain, or stored privately off the ledger. When one kind of cryptocurrency is traded for another, the short and long term capital gains must be calculated, depending on how long the crypto was held, as well as the difference between the original cost basis of the crypto and the final sell price.  

Trading Via Exchanges 

If cryptocurrency is traded in a transaction on a cryptocurrency exchange, the value of the cryptocurrency is the amount that is recorded by the cryptocurrency exchange for that transaction in U.S. dollars.  

If the transaction is facilitated by a centralized or decentralized cryptocurrency exchange but is not recorded on a distributed ledger, or is otherwise an off-chain transaction, then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction. 

Peer-to-Peer Trading 

The fair market value of cryptocurrency received in peer-to-peer transactions or other non-exchange transactions is the value of the cryptocurrency at the date and time the transaction is recorded on the ledger.  

For off-chain trades, the fair market value of the cryptocurrency is the value at the date and time it would have been recorded on the ledger. But the value of this cryptocurrency at the exact time of these types of trades is not always known or easy to verify. 

The IRS will accept as evidence of “fair market value” the value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time. Any other valuation of a cryptocurrency other than an explorer value requires proof that it is an accurate representation of the cryptocurrency’s fair market value. 

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Forks The new Rev Rule 2019-24 and IRS “Frequently Asked Questions on Virtual Currency Transactions” provides guidance for soft and hard forks. The only taxable type of blockchain fork is a hard fork that creates and distributes new cryptocurrency to the taxpayer.  

One way taxpayers may receive cryptocurrency following a hard fork is with an airdrop. An airdrop is a quick method for distributing cryptocurrency to multiple accounts or addresses. A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. Cryptocurrency from an airdrop generally is received on the date and at the time it is recorded on the distributed ledger. 

According to RR 2019-24, a taxpayer that receives crypto that is not purchased, such as forked crypto that is airdropped, will have ordinary income in the taxable year the new crypto is received. The taxpayer’s cost basis is the fair market value of the crypto at the time it is received.  

To determine fair market value, it is key to determine when the taxpayer has receipt of the new airdropped crypto. Like other gains included in gross income, it is only after the taxpayer has complete “dominion and control” over the crypto, that the taxpayer officially owns it. A taxpayer has “dominion and control” of the new crypto when they can transfer, sell, exchange, or otherwise dispose of it. This is generally the date and time the airdrop is recorded on the distributed ledger, but of course there are always exceptions.  

For example, a taxpayer does not have “dominion and control” if the exchange to which the cryptocurrency is airdropped does not support the newly-created cryptocurrency. When that happens, the airdropped crypto is not immediately credited to the taxpayer’s account in the exchange. If the taxpayer later acquires “dominion and control,” meaning they have the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, the taxpayer is treated as receiving the cryptocurrency at that time.  

Mining As a review, in cryptocurrency, mining is the process of validating and adding new blocks to the blockchain, which is done by automated computing devices. The term “miners” can refer to either the computing devices doing this work or the owners of those devices. A transaction is the transfer of any information between accounts on the blockchain. Before being validated, transactions are bundled into large groups, known as blocks. Then, miners validate the block before adding it to the blockchain. Validating a block involves competing to solve extremely complicated and energy- and time- consuming mathematical equations. Once a solution has been found, it is uploaded to the entire network to be accepted and 

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added to the blockchain. Miners are rewarded for “winning a block” with transaction fees and cryptocurrency.  

Miners often operate with groups of other miners, known as mining pools, to increase their chances of winning a block. If miners participate in mining pools, they will have income and expenses from the pools they participate in. 

There are taxable events related to miners and mining. The tax regulations related to mining are applicable to individuals who have business income and expenses related to mining.  

According to the AICPA’s letter in Section 4, Q&A 8 of Notice 2014-21, “when a taxpayer successfully ‘mines’ virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.” 

There are two taxable events related to mining: when cryptocurrency is received for mining and when crypto received from mining is disposed of. 

When a taxpayer receives crypto for mining, it is taxed as ordinary business income based off of the fair market value of the crypto at the time it was mined. The holding period begins immediately after the taxpayer receives the crypto. Then, when they dispose of the cryptocurrency, the taxpayer will recognize short and long term capital gains based on how long it was held.  

The costs of mining virtual currency should be treated the same as expenses incurred in providing other services (i.e., expenses as “paid or incurred”).  

The matching of income and expenses are consistent with other service activities. Virtual currency mining equipment is capitalized and depreciated like any other property whose useful life extends beyond one year. If a taxpayer owns a mining business, write-offs might include costs for computing and cooling equipment, internet and power bills, buildings, and staffing. These are similar to write-offs for other business owners. 

Crypto Paid as Income Occasionally, employees or independent contractors can be paid for their services with virtual currency. 

Like all crypto a taxpayer receives that is not purchased, cryptocurrency income is recognized in the taxable year the crypto is received. The taxpayer’s cost basis of the cryptocurrency is the fair market value of the virtual currency, in U.S. dollars, when it is received. In on-chain transactions, virtual currencies are received on the date and at the time the transaction is recorded on the distributed ledger. If virtual currency is paid in an 

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off-chain transaction, or any transaction that is not recorded on an exchange or blockchain, receipt is the day and time it is transferred to the taxpayer. 

If crypto received in exchange for any service doesn’t have a published value on any exchange or blockchain, the fair market value of the cryptocurrency received is equal to the fair market value of the services exchanged for the cryptocurrency when the transaction occurred. 

Virtual currency received from employers is reported as ordinary income. The fair market value of virtual currency paid as wages is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement.  

For independent contractors, the fair market value of virtual currency received for services constitutes self-employment income and is subject to the self-employment tax. This income is reported on Form 1099. 

One-off Transactions  

Buying Something with Crypto/Transactions Using Crypto (Payer) Cryptocurrency can be used to pay for goods and services, and the number of individuals and companies accepting it as payment is increasing constantly.  

Publication 544, Sales and Other Dispositions of Assets states that if a taxpayer pays for a service using virtual currency that they hold as a capital asset, then the taxpayer has exchanged a capital asset for that service and will have a capital gain or loss. The capital gain or loss is the difference between the fair market value of the services received and the adjusted basis in the virtual currency exchanged. 

If a taxpayer exchanges virtual currency held as a capital asset for other property, including for goods or for another virtual currency, they will recognize a capital gain or loss. The capital gain or loss is the difference between the fair market value of the property received and the adjusted basis in the virtual currency exchanged. Publication 551, Basis of Assets states that when virtual currency is transferred in exchange for property, the cost basis in that property is its fair market value at the time of the exchange.   

Long and short term gains must be calculated for crypto used to purchase goods or services as well.  

Under the proposed Token Taxonomy Act, these types of transactions have the potential to apply the de minimis rule. If the difference between the cost basis of one’s cryptocurrency investments and the cost of goods or services being purchased is less than $600, then this would not be a taxable event. If the gain is more than $600, the event would need to be 

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included in tax filings. While this proposed act is still in committee, if passed it would help encourage the use of crypto for everyday purchases rather than larger, more costly purchases. 

Selling Something for Crypto/Crypto as Payment (Payee) Publication 544, Sales and Other Dispositions of Assets provides guidance for this section. 

Selling something for cryptocurrency is not taxable unless the amount received for an asset exceeds the basis of that asset. If the amount received exceeds the asset basis, the taxes should be calculated based on how long the original asset was held. The short and long term capital gains should be calculated. 

If a taxpayer sells property held as a capital asset in exchange for virtual currency, they will recognize a capital gain or loss. If they transfer property that is not a capital asset in exchange for virtual currency, they will recognize an ordinary gain or loss.  

The gain or loss is the difference between the fair market value of the virtual currency when received (usually when the transaction is recorded on the distributed ledger) and the adjusted basis in the property exchanged.  

If, as part of an arm’s length transaction, a taxpayer transferred property to someone and received virtual currency in exchange, their basis in that virtual currency is the fair market value of the virtual currency, in U.S. dollars, when the virtual currency is received.   

If cryptocurrency that is received in exchange for property or services does not have a published value on any blockchains or exchanges, then the fair market value of the cryptocurrency received is equal to the fair market value of the property or services exchanged for the cryptocurrency when the transaction occurs. 

Refer to Publication 551, Basis of Assets to read more about determining the basis of crypto assets. 

ICOs/STOs  Cryptocurrencies acquired as Initial Coin Offerings (ICOs) fall under property laws just like other cryptocurrencies: long and short term capital gains are calculated the same way. 

Cryptocurrencies acquired as Security Token Offerings (STOs) fall under federal security laws rather than property laws. STOs are taxed only when they’re disposed of. This means long and short term capital gains are calculated at the time of disposal. 

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Miscellaneous Reporting 

Foreign Reporting All centralized exchanges residing outside the United States are categorized as foreign bank accounts because the exchanges have custody of the virtual currencies. Thus they fall under foreign banking reporting rules, according to the Banking Secrecy Act. If the amount of crypto or FIAT held in these foreign exchanges exceeds $10k, that information needs to be reported on the FBAR form that is used to declare assets outside the US. 

If the taxpayer owns virtual currency in foreign exchanges but they retain control and are in possession of the private keys for their wallets, it is not considered a foreign banking account.  

As explained in the AICPA Comment letter on Notice 2014-21: “When the taxpayer owns, controls, and is in possession of the private key, the virtual currency resides in the country of the taxpayer’s residence. In the case of a U.S.resident, the virtual currency by definition resides in the U.S.There is no Foreign Financial Institution or financial institution of any kind because the taxpayers maintain possession similar to cash or gold. The same principles apply to both the FBAR and the Foreign Account Tax Compliance Act.” 

“An IRS analyst for the Small Business/Self-Employed Division (SBSE) stated, inJune of 2014, that virtual currency accounts were not reportable on the Form 114, Report of Foreign Bank and Financial Accounts, for tax years ended 2014.” But guidance was provided for any future years regarding foreign reporting. Guidance from the IRS and Treasury is needed regarding whether virtual currency accounts will become reportable on Form 114 in future years, and “whether there are circumstances that may alter virtual currency accounts into foreign financial assets under section 6038D, and therefore require reporting on Form 8938”.  

Dead Crypto Dead cryptocurrency is any cryptocurrency investment that is now worthless. Dead cryptocurrency can be the result of a couple of different situations. For example, a dead crypto could be a crypto that has been delisted from the exchanges it was previously listed and so can no longer be traded. Dead crypto can also be the result of a fork in the crypto blockchain where the forked blockchain is unsuccessful, meaning the corresponding crypto becomes worthless.  

The guidelines for determining when a virtual currency is dead have not been directly addressed. The closest current analogy is the rules for evaluating worthless stocks, which can be used for guidance for evaluating and reporting dead crypto.  

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According to http://apps.americanbar.org/buslaw/committees, “A taxpayer is permitted to report a loss in a security equal to its tax basis when the security becomes completely worthless during a tax year under Treasury Regulation 165.1...the loss must be (a) evidenced by a closed and completed transaction, (b) fixed by identifiable events, and (c) actually sustained during the taxable year. The Code, however, does not define “worthlessness.” A single event will not generally satisfy the worthlessness test in the absence of other factors that indicate that no value remains in the security, thereby making this a difficult hurdle.” 

If the resulting crypto from a fork becomes worthless, the following information from the AICPA can be used as guidance for tax filings:  

If a taxpayer fails to execute a crypto token exchange as the result of a fork in the blockchain’s technology, the resulting cryptocurrency is considered a “worthless security” under section 164 Form 8949. “Taxpayers should report virtual currencies that become worthless on Form 8949, Sales and Other Dispositions of Capital Assets, thus applying the same methodology used for worthless securities.” 

According to http://apps.americanbar.org/buslaw/committees, “If a taxpayer can determine worthlessness, [they} must also prove that the recognition of the loss in a particular taxable year is appropriate. A loss for worthlessness generally can be claimed in a year in which a security is abandoned by a taxpayer. In order for a security to be considered abandoned, a taxpayer must permanently surrender and relinquish all rights in a security and receive no consideration in exchange for the security. Again, this is a facts and circumstances test, and taxpayers must ensure the transaction is properly characterized as an abandonment rather than another type of transaction, such as an actual sale or exchange, contribution to capital, or a dividend.”  

Once a cryptocurrency is determined to be dead, the value invested in the cryptocurrency (the basis) can be written off as a loss on tax returns for that year, and short or long term capital loss can be calculated. 

Accounting Methods for Valuation The accounting methods for valuing cryptocurrencies will be the same methods used when dealing with traditional property or security filings. What method works best to maximize benefits on gains and losses will differ from client to client. Some methods include: 

● First In, First Out (FIFO) Based on the most recent guidance, FIFO is the default accounting method used in conjunction with SI. This is considered the default method for accounting crypto. If specific units of virtual currency are not identified, the units are deemed to have been sold, exchanged, or otherwise disposed of in chronological order beginning 

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with the earliest unit of the virtual currency purchased or acquired; that is, on a first in, first out (FIFO) basis. 

● Last In, First Out (LIFO)  ● Highest in, First Out (HIFO) 

HIFO refers to the valuation method of determining the highest cost basis of all owned crypto and using that as the cost basis for the asset being disposed of. 

● The Weighted Average Method  This method uses the total cost for each specific type of crypto and assigns an average cost to each cryptocurrency as the basis for when it is sold during the year. 

● Specific Identification (SI) In this method, specific identities are assigned to each specific asset, and valuation is based on tracking the related cost basis and sale price for each individual asset. 

Forms The following forms are used in filing cryptocurrency taxes. 

● Form 8949. This form summarizes all activities of each asset type separated by long and short term transactions on this form, provided all of the details are retained in the event of an audit. “You must report most sales and other capital transactions and calculate capital gain or loss in accordance with IRS forms and instructions” (IRS FAQ Q&A 40). 

● Ordinary income from virtual currency is reported on Form 1040, U.S. Individual Tax Return, Form 1040-SS, Form 1040-NR, or Form 1040, Schedule 1, Additional Income and Adjustments to Income, as applicable. 

● Form 1099 misc. This form is applicable if the taxpayer is paid with crypto for services as an independent contractor. 

● Form 1040 line 21. The Hobby Loss Rules apply to any other income made, such as mining crypto as a hobby. The value of coins earned will be listed on this form as “other income,” and the ability to deduct expenses associated with the mining is limited to the 2% rule. 

● Form 1040 schedule D. All capital gains and deductible capital losses must be summarized on this form. (IRS FAQ Q&A 40) 

● Form 1099 K. This form, originally used for mass credit card processors, is being adapted for cryptocurrency exchanges who report on account owners with more than 200 transactions and more than 20k in gross proceeds. 

For individuals who mine as a business, earnings are reported based on the entity type. Use the standard forms: 1040 schedule C,1065, form 1120, and form 1120S. 

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Audit Preparation 

As stated on IRS website, under the frequently asked questions on virtual currency, a taxpayer “must report income, gain, or loss from all taxable transactions involving virtual currency on your Federal income tax return for the taxable year of the transaction, regardless of the amount or whether you receive a payee statement or information return.” (IRS FAQ Q&A 39) 

With the recent issuance of the 10,000 letters from the IRS on July 26, 2019, making sure documentation and backup statements are prepared in the case of an audit has become a very real and, for the recipients of those letters, urgent necessity.  

All crypto filings must be documented and have backup statements. For this, use Form 8949. Even though all the transactions can be summarized in an 8949 and aren’t required to include every single cryptocurrency transaction, documentation to verify every transaction in case of an audit must be kept. 

“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.” (IRS FAQ Q&A 43) 

Closing This unit explained current and upcoming tax regulations and guidance, identified taxable and non-taxable events, and reviewed the accounting methods and forms used for cryptocurrency.  

   

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Resources

Top 50 Cryptocurrencies Bitcoin Ethereum XRP Bitcoin SV Bitcoin Cash Tether Litecoin EOS Binance Coin TRON Monero Cardano Stekkar Tezos UNUS SED LEO Cosmos Chainlink Dash Ethereum Classic Neo Huobi Token HedgeTrade IOTA Crypto.com Coin Maker USD Coin Ontology Zcahs VeChain NEM Dogecoin Basic Attention Token Paxos Standard FTX Token Decred Bitcoin Gold Qtum

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Synthetix Network Token TrueUSD 0x Ravencoin OKB Algorand Holo Augur ZB Token OmiseGO Centrality Seele Bitcoin Diamond

List of Hot and Cold Wallets

Cold Wallets: Trezor Ledger Bitcoin Core Armory Electrum

Hot Wallets: Abra. AtomicWallet Bakkt Bittrex Blockchain.com Coinbase Coinomi Electrum Exodus Gemini Jaxx Kraken MyCrypto wallet MyEtherWallet

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List of Cryptocurrency Exchanges Bibox BiKi Bilaxy Binance Bitfinex BitForex Bitmart Bitpanda Bitstamp Bittrex Bitz Cex.io ChangeNow Coinbase Coineal Coinmana Coinsbit Cryptotopia DCoin DigiFinex EXX Gemini HCoin Gotbit Huobi Global Kraken KuCoin LocalBitcoin MXC OKEx P2PB2B Poloniex

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Glossary Address

A public address is a value generated by a public key associated with a wallet, and is used as the public address to which cryptocurrency is sent or from which it is received.

Block Hash The number algorithmically generated by the miner compiling the block, which identifies the block when it is broadcast to the network to be confirmed by other miners on the blockchain.

Blockchain A decentralized digital ledger that records and tracks all accounts and transactions that use its peer-to-peer network. This public digital ledger is shared with all the computers in the blockchain network.

Coins Cryptocurrencies native to their own blockchain. They hold value as a medium of exchange, just as normal government-backed cash.

Cold Storage Wallet A wallet that stores cryptocurrency keys offline. It may be as simple as a piece of paper or physical record of the keys, or a device unconnected to the internet. (See Wallet.)

Cryptocurrency A specific type of virtual currency. Most cryptocurrencies are built on important decentralized ledger technology called blockchain.

Cryptocurrency Tokens See Tokens.

Cryptocurrency Transaction See Transaction.

Exchanges Online platforms where cryptocurrencies can be publicly traded.

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Extended Public Key A feature of some types of wallet, which allows multiple public addresses to be generated linked back to one account.

Fork A change or divergence in the once singular path of an existing distributed ledger, either altering the original path or creating a completely new alternative route. Forks are created through changes to the software of an existing blockchain system.

Hard Fork A major change in a blockchain’s protocol rules such that the new protocol is not backward compatible with the previous legacy protocol. (See Fork.)

Hot Storage Wallet A wallet which runs on internet connected devices. They may be software wallets, downloadable programs; online wallets accessible via web browser; or exchange-based wallets that exist within cryptocurrency exchange markets. (See Wallet.)

ICO Initial Coin Offering. Similar to an Initial Public Offering for regular stocks. A coin is created and offered to investors in order to raise capital for expansion and development. ICOs are unregulated by governments, and despite the name usually involve the creation and sale of tokens.

Miners The computing devices, or the owners of the devices, that confirm and validate transactions added to the blockchain.

Mining The process of verifying and adding transactions to the blockchain ledger by solving difficult mathematical equations.

Mining Pools Groups of computers that share processing power over a network, pooling resources in order to increase chances of being the first to mine, or “win” a new block.

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Mining Rewards Incentives given to miners for winning blocks and verifying transactions. This is an amount of cryptocurrency awarded to the miner that first wins a block, as well as small transaction fees for every transaction a miner verifies in a block.

Proof of Work The method used to validate transactions; a miner bundles pending transactions into blocks containing up to 3000 transactions, then signs it by using a complex algorithm to solve a complex puzzle. This generates a unique number that identifies the new block of transactions.

Private Key A cryptographic key, consisting of a string of alphanumeric characters, which is used to prove ownership and retrieve cryptocurrency.

Public Key A cryptographic key algorithmically generated from a private key to identify and confirm the private key and verify transactions.

Seed Phrase A series of words algorithmically generated from a private key, which serves as a more memorable and user-friendly way to retrieve a private key.

Soft Fork Any minor change or update to a blockchain’s code that doesn’t conflict with previous versions of the blockchain and is thus backward compatible; old blocks mined with the previous protocols are still recognized as valid by the new software. (See Fork.)

STO Security Token Offering. Similar to an ICO. STOs are regulated by the governments in which they operate whereas ICOs are not. Like ICOs, STOs can be offered in the form of crypto coins or tokens.

Transaction A transaction is the record of three important pieces of information: who, what, and when. Who: the addresses of the sender and receiver; what: the item(s) being transferred; and when: the time when the transaction occurred. The transaction is initiated from an address, signed with private keys, broadcast to the network, confirmed by miners, and then added to the blockchain.

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Types of transactions:

1. Buying: purchasing crypto with FIAT, a government-issued and back currency, or any other asset.  

2. Selling: disposing or getting rid of crypto assets.  3. Receiving/depositing: being paid with or given cryptocurrency.  4. Sending/spending: paying for something using crypto.  5. Transferring: when a user moves crypto from one account or wallet 

that they own to another that they own.  6. Trading: exchanging one form of crypto for another.

Tokens Cryptocurrencies that have value in that they represent a real world tangible asset or utility. Security tokens can represent stakes in stocks, assets, or other types of cryptocurrency. Utility tokens give ownership or access to a specific service.

Virtual Currency A digital representation of value that is not issued or guaranteed by a public authority, like a government.

Wallet A device or piece of software which stores public and private keys.