Can the expense of purchasing a bitcoin cloud mining contract as a hobby be deducted? Also how are the re-invested daily earnings handled from a tax perspective?

[thepep]

I purchased a bitcoin cloud mining contract as a hobby/investment and not as a self employed business.  Let's say cost is $5,000.  I understand that each daily bitcoin payout has to be counted as income for tax purposes.  I have not sold any of the earned bitcoin yet but i understand when i do it is a taxable capital gain or loss.  Questions: (1) Am I correct in that the $5,000 expense can be included as an itemized deduction subject to 2% of my adjusted gross income?  (2) I read that the amount that can be claimed as an expense cannot be greater than the income from the hobby.  In my situation, I purchased or incurred the $5,000 expense near the end of December 2017 so there was only ~ $800 of income generated by the end of 2017.  Does the bulk of the $5,000 expense deduction get "wasted" since most of the income from my $5,000 purchase will be generated in 2018?  Finally, (3) what are the tax implications (if any) regarding the fact that I chose to automatically re-invest my daily earnings to purchase additional hashrate?  Would that be considered a "sale" and therefore a short term capital gain or loss?  Or is the re-investment amount an expense like the original $5,000 amount?  Basically I used my earned bitcoin to purchase additional hashrate which means that bitcoin is "spent".  Thanks for any opinions!!

[AmandaR1]

This is a newer tax situation, so there's not much specific instruction from the IRS, but they have made it clear that cryptocurrency is taxable as capital asset sales, just like stocks. I'm going to answer your questions in a different order. 

• 3) Just like stocks, regardless of if you received cash, any trade, exchange, etc. is considered a sale. This would include reinvesting earnings, just like reinvesting stock dividends or earnings from a stock, into another stock. Obviously with Cryptocurrency and the situation you are describing this can be a tedious calculation. I've heard some people are tracking this with complex spreadsheets. 

It sounds like you are aware that also using cryptocurrency to make a purchase of goods or services, results in a capital sale (but worth mentioning!), so the treatment is consistent. 

• 1 &2 ) Yes, that's correct, but not the full $5,000. If you report $800 of hobby income, you can only report $800 of hobby expenses.  Hobby expenses are only deductible up to the amount of earnings, as an itemized deduction (not directly from the income). The hobby expenses are then reduced by 2% of your Adjusted Gross Income (a subtotal on page 1 of your 1040, which includes your hobby income). So, you can loose the entire deduction fairly easily at this point, depending on your AGI. Additionally, as a deduction, this may not benefit you at all unless you itemize (if you take the standard deduction there's no deduction). 

While hobby may be a smart distinction because this could save you time in entry, if you choose to do a hobby, I wouldn't recommend changing it when it's more favorable to you. The hobby classification is a strict classification and if your goal is to make a profit, then you don't qualify.  Hobby income is reported on line 21, as other income.  Learn more about classifying your activity as a hobby here: https://www.irs.gov/newsroom/is-your-hobby-a-for-profit-endeavor

Additionally, your $5,000 investment is your cost basis in the cryptocurrency.  When you sell, trade, etc. your cost basis reduces the sale price, to equal your gain or loss. This would be most likely be more advantageous anyway. Also, investment expenses can be deducted as an itemized deduction too, but this doesn't include your cost basis of purchasing. 

Some good resources:

• IRS guidance: https://www.irs.gov/pub/irs-drop/n-14-21.pdf
• Forbes article: https://www.forbes.com/sites/kellyphillipserb/2018/01/09/what-you-need-to-know-about-taxes-cryptocur...

[thepep]

Thanks for clarifying the re-investing situation.  I do itemize.  So I spent $5k in 2017 on the overall investment purchase and earned $800 in 2017.  I can only claim $800 (out of the $5k) of hobby expenses in 2017?  Am I correct in assuming that the balance of the original expense ($4,200) does not help to possibly offset the assumed income to be earned in 2018 as an itemized deduction since the $5k was spent in 2017 and can't be carried over?  Or can I use that $4,200 balance on my 2018 tax return?

I am confused on your last statement regarding the $5k initial investment being my cost basis.  The $5k was used to purchase a certain amount of mining hashrate that is used to mine the bitcoin.  To me this is an expense.  The basis of the cryptocurrency earned on a daily basis is the fair market value of each daily payout at the time of payout.  Am i missing something?

[RK3]

I asked a similar question in the past and never got a solid response and they finally removed my question completely. I don't think Turbotax guys have the knowledge in answering this question and most likely this post will also be removed.

In fact I couldn't find anything on the net directly addressing core issue here. I believe most of the guys who buy contracts skip paying taxes on such cases because IRS didn't care to clarify this 🙂

Here is what I believe should happen - when you bought the contract for $ 5000, consider it as buying some good with shipment dates into the future. As you get payouts (as if batches of goods arriving), you will track the price of crypto as on those dates and deduct from your original contract (doesn't matter if you reinvest or take payment out). Until you reach the 5k value you are not making any money and therefore no taxes. Your cost basis will be the prices as per dates of payouts. Once you cross above 5k, you will start reporting those as income and pay taxes on those payout even if you don't sell them.

I am no tax expert, but I don't see any reason why IRS would want to deduct your taxes until you make money on the contract. You are not mining and therefore it is not a hobby for you. You purchased a service from someone who does the mining as a business.