How Would A Digital Dollar Be Taxed?

Technology has had a huge impact on our lives. One area that has seen significant change and promise is digital currency, to the point where the U.S. government is considering the implementation of digital currency. If this happens, the Federal Reserve (the Fed) would issue a central bank digital currency which would act as a digital version of the country’s legal tender. Central bank digital currency would be government issued or considered as “fiat currency”–a paper, legal tender that is not backed by a commodity, like gold. Currently, there are nine countries that have developed their own central bank digital currency.

There are a lot of questions surrounding the U.S. dollar digital currency, especially when it comes to taxes. Here, we answer some of the most-asked questions regarding digital currency and taxes.

What is Digital Currency?

The IRS defines digital currency as “the virtual or digital value of something or a medium of exchange other than in the form of a U.S. dollar or other foreign exchange.” If an asset shares the same characteristics of virtual currency, it will be treated as such for federal income tax purposes.

Is the U.S. Going to Digital Currency?

In March of 2022, headlines were made when President Biden signed an Executive Order directing the Fed explore digital currency options. Now, the Fed is looking into the possibility of creating a U.S. dollar digital currency which would be backed by a central bank. They are currently evaluating the potential impact of implementing such a system.

Part of this evaluation process includes the exploration of potential benefits and risks of having a U.S. central bank digital currency and if the central bank digital currency would improve upon a financial system in the U.S. – a system that is already safe and efficient.

There are always benefits and risks to everything. Some of the benefits of having a central bank digital currency is that it would be more convenient, offer lower cost transactions, eliminate the need for cash, be an efficient way for the government to collect on taxes, and reach Americans who don’t have bank accounts.

There are risks to implementing such a system as well. These include technology barriers, privacy threats, cybersecurity threats, and possible political abuse.

Will Digital Currency Replace the U.S. Dollar?

No. A U.S. central bank digital currency will not replace U.S. paper currency or the U.S. dollar. Cash and paper currency will still be available.

The digital currency will be in addition to the current paper currency already established in the U.S. The central bank digital currency will reach those who don’t have bank accounts or who want another or alternative option within the financial financial system.

The centrality of the U.S. dollar would remain prevalent in the global economy and financial markets. In fact, the Fed has indicated the belief that a U.S. digital bank would help to keep the dollar an important benchmark in the world economy.

Do You Pay Tax on Digital Currency?

According to the IRS, digital currency is treated like property. You don’t pay tax for holding digital currency, but you do pay taxes if you use digital currency in a transaction or if you sell it. Either one of these scenarios will result in a capital gain or loss and you will be taxed as such. When digital currency is received as a payment for business purposes, it’s taxed as business income.

Since digital currency acts as a medium of exchange, stores value, and can be substituted with real physical money, any income or profit resulting from your digital currency is taxable.

How is Digital Currency Taxed?

Digital currency is considered as property for tax purposes. Your digital currency will be taxed just like any other assets you own, like stocks, for example.

Not all digital currency activities need to be reported to the IRS, but it’s crucial that those required are reported on your tax return. Some examples of digital currency activities that should be reported on your tax return include selling digital currency for fiat money, trading digital currency for other digital currency, or using digital currency to buy a good or service.

There are also some cases where digital currency transactions do not result in a taxable event. Some of these non-taxable events include buying digital currency with fiat currency, donating digital currency to a tax-exempt organization (though you would likely still want to report it for the deduction), directly gifting digital currency under the annual gift exclusion amount, and transferring digital currency from one wallet to another.

How Are Capital Gains Tax on Digital Currency Treated?

Gains on digital currency are treated like other capital gains. For digital currency held less than a year or short-term capital gains, you’ll pay ordinary tax rates. In 2022, tax rates range from 10% to 37% depending on the amount of your income. For digital currency held longer than a year, you’ll pay the long-term capital gains rate which is lower than the short-term. This rate is usually 0%, 15%, or 20%.

You can net capital gains and losses of digital currency against each other to decrease your tax exposure. You can also deduct the capital losses of digital currency and realize a net loss of up to $3,000 a year as an individual. If your net losses exceed this amount, you can carry them over to subsequent years.

Would a Federally Backed Digital Currency be Taxed Differently?

As discussed, digital currency is currently taxed either as personal property and subject to capital gains rates, or it is taxed as ordinary income when received as payment. But if the Fed establishes a Central Bank of Digital Currency with a government supported digital currency, would the currency still be classified as “property” or would it be treated more like cash?

Fortunately, the Fed has already been doing some research on this topic, which gives us some clues as to how a digital dollar would ultimately work. Under the “Central Bank Digital Currency,” the digital currency created would almost certainly function similar to what are called “stablecoins” – cryptocurrency that is tied to a country’s currency to avoid the volatility of most other cryptocurrencies. A stablecoin created and backed by the Fed, pegged to the value of the dollar, would almost certainly always be treated as cash, instead of as a digital asset/personal property.

Time will tell what a Central Bank Digital Currency will look like. While a digital currency may be years away, tax planning is always in fashion! 

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