Cryptocurrency has gained a lot of interest all over the world in recent years. Both individual consumers and corporations are exploring the addition of cryptocurrency to their investment profiles, and some users are beginning to utilize cryptocurrency as a form of payment for goods and services.
Since cryptocurrency is a relatively new and evolving technology, there is a lot of conflicting information out there about it.
This is especially true when it comes to tracking cryptocurrency for accounting purposes, as the financial reporting for these assets doesn’t fit cleanly into existing US generally accepting accounting principles (GAAP).
At Wood CPA, we have learned a few things about how to handle accounting for cryptocurrency, so we thought we’d offer a few basics you should know if you’re considering investing in this digital asset.
What is Cryptocurrency?
If you’re not yet familiar with cryptocurrency, it is a digital form of payment that can be traded for profit or exchanged online for goods and services.
Cryptocurrencies use a technology called blockchain, a public digital ledger of transactions that records information in a way that makes it difficult to hack or alter, making it highly secure. Blockchain is also a decentralized technology, meaning it is disconnected from intermediaries like banks or other third parties.
There are more than 10,000 different cryptocurrencies currently being traded publicly, Bitcoin being the most well-known example.
Due to the high level of security afforded by blockchain, as well as the decentralized nature of cryptocurrencies that removes central banks from the picture, the use of cryptocurrency is quickly gaining in popularity.
How Should Cryptocurrency Be Recorded in the Ledger?
Because cryptocurrency is so new, there is naturally a lot of confusion over how it should be tracked in the general ledger. But ultimately, cryptocurrency is an asset, and should be treated accordingly.
When cryptocurrency is purchased, it should be recognized on the balance sheet at its fair market value on the date of purchase. It should be recorded as a debit to the new asset account and a credit to the cash account for the same amount.
Cryptocurrency is volatile, with frequent ups and downs in value. As its value changes over the course of ownership, the necessary journal entries should be made to account for any impairments as they occur.
Then when the cryptocurrency is sold, the opposite should happen: the asset should be credited to remove it from the balance sheet at its book value, and the cash account should be debited in the amount of the proceeds or other consideration received (unless it is exchanged for another digital asset, in which case the new cryptocurrency account should be debited).
If proceeds at sale are higher or lower than the asset’s current book value, a capital gains or loss account should be credited, reflecting the difference between the book value and the proceeds received.
When Are Cryptocurrency Transactions Taxable vs Non-Taxable?
Some cryptocurrency transactions are taxable, but not all. Taxable events include (Click on the links below to learn more about each of these events):
The proceeds from any of these events are taxable as ordinary business income. You can, of course, deduct any necessary expenses associated with these activities, reducing your tax liability.
In some cases these events may trigger capital gains or losses as well. In general, any disposal of your cryptocurrency for proceeds that are different from the cost basis will trigger capital gains or losses, including selling it, exchanging it, or using it to pay a vendor.
All other cryptocurrency events are non-taxable, including:
- Buying cryptocurrency with fiat currency,
- Transferring like-for-like cryptocurrency assets between exchanges, and
- Donating cryptocurrency or giving it as a gift
Is the IRS Tracking Cryptocurrency?
The short answer is yes, the IRS is tracking cryptocurrency.
In part because of its rising popularity, the IRS is keeping a close eye on who has or uses cryptocurrency, and it is being heavily audited right now. In fact, for the 2020 tax year the IRS added a question to the front page of the 1040 tax form asking taxpayers about their use of cryptocurrency (previously the question was included in Schedule 1).
The main reason that the IRS is so concerned with cryptocurrency is that in some cases it has been used for money laundering. In addition to the question included on Form 1040, the IRS is also using data analytics to uncover some cryptocurrency transactions in an attempt to track potential criminal activity.
As we mentioned above, the blockchain technology used in cryptocurrency transactions is incredibly secure. This means that, to a point, cryptocurrency holdings are anonymized. However, when cryptocurrency is used to purchase goods or services, it leaves a money trail that the IRS can track if they suspect criminal use such as money laundering.
But assuming you’re not trying to launder money and that your cryptocurrency holdings are accounted for properly, you don’t need to worry, even if you are audited.
Questions About Accounting for Cryptocurrency? Wood CPA Can Help
There is a lot of confusion surrounding cryptocurrency, so don’t hesitate to reach out if you have additional questions about accounting for cryptocurrency or the tax implications of investing in it. Wood CPA is more than happy to help — give us a call at 952-356-1110 or contact us here.