The growing popularity of crypto assets means that owners and their tax advisors need to be aware that tax authorities are taking an interest in these assets as well.
Until now, the Internal Revenue Service (IRS) hasn’t been very aggressive about pursuing cryptocurrency investors who under-report their crypto earnings. But investors poured more than $30 billion into the crypto market last year, and many of the most popular cryptocurrencies increased in value at an extraordinary rate (for example, Bitcoin grew in value by 94%; Ethereum by 494%; and even Dogecoin, which started as a joke, climbed by 2,899%.)
So naturally, the IRS wants its cut.
To avoid any IRS headaches, crypto hobbyists and professionals alike will need to be much more transparent about their crypto dealings when filing their 2021 taxes. And for some, accounting for a year’s worth of crypto exuberance may present some unexpected difficulties.
Crypto transactions can qualify as “taxable events” in several ways, depending on the nature of the transaction.
In general, the IRS treats crypto assets like stocks, bonds, or property, which means they aren’t taxable until one sells or uses them. Normal capital gains taxes could apply to such transactions — short-term capital gains taxes if the crypto asset was owned for less than a year; and long-term capital gains taxes if it was owned for more than a year. But if all an investor did was buy some Bitcoin and hold onto it, there is no need to report it to the IRS.
However, a rude surprise may await those who got swept up in last year’s meme-stock mania and spent a lot of their pandemic lock-down time trying to game the volatility of the crypto market by buying and selling many different cryptocurrencies in a short time frame — because yes, the IRS thinks of each one of those transactions as a taxable event.
Looking for more information about cryptocurrencies and their regulation? You can download Thomson Reuters’ new Cryptos on the Rise 2022 report here.
Further, crypto exchanges aren’t yet required to provide their users with tax documents. That means it is the responsibility of individual crypto owners or their CPAs to keep track of all the gains and losses that their feverish crypto activity generated, including how long each crypto purchase was held, its fair market value when it was bought and sold, and any fees that may be associated with the transaction.
Some of the more popular exchanges — such as Coinbase, Bisq, or public.com — do provide users with a consolidated 1099 tax form and make it possible for users to download their transaction history, but many more don’t. And even if they do, individual owners will still have to calculate gains and losses based on the price of the crypto asset when it was bought and sold.
Crypto’s trickier side
Crypto assets can be used in many different ways, and this is where it gets a bit trickier. For example, crypto assets can be used to pay for products and services; traded for other cryptocurrencies; to pay (or receive payment) for non-fungible tokens (NFTs); to invest in start-up businesses; or even be mined, which means earning crypto by participating in its underlying blockchain authentication process.
In the eyes of the IRS, any time crypto is used as a medium of exchange, it becomes taxable. Precisely how it is taxed, however, depends on the nature of the transaction and the value of the taxpayer’s capital gains or losses.
For example, if someone pays for a good or service with crypto, and profits from the difference in price between the good or service and the purchase price of the crypto, then the profit is reported as ordinary income. Mined crypto earnings are also taxed as income. However, if one sells or trades crypto, any profits are taxed as capital gains, just as if they were selling a stock. Likewise, an individual can write off up to $3,000 worth of crypto losses, and carry forward any additional losses to offset gains in the future.
Cryptos also have their own version of a stock split, called a “fork.” There are hard forks and soft forks, and potential tax consequences for each.
A soft fork can be thought of as a brand extension, as when Bitcoin soft-forked into Bitcoin Gold, Diamond, Private, etc. But the tax consequences of a soft fork are typically neutral, because the overall value of an investor’s assets after the fork stay the same.
On the other hand, a hard fork is when an entirely new cryptocurrency is created, and its value appreciates or depreciates in a separate blockchain from the original crypto. Again, as long as the overall value of an investor’s assets remain the same, there are no tax consequences. But new tokens from a hard fork are often given to investors as a gift or what’s known as an “airdrop,” and the value of these additional assets are taxable as a capital gain.
NFTs are another digital asset that may or may not interest the IRS. Unlike fungible tokens such as Bitcoin and Ethereum, NFTs are one-of-a-kind tokens that can’t be duplicated. At the moment, NFTs are being used mostly by artists and musicians to ensure the authenticity of a work through its unique blockchain. And for investors who buy them, an NFT’s value is directly linked to its uniqueness.
For most NFT transactions, however, taxation isn’t complicated. Basically, if someone creates or purchases an NFT, then sells or trades it, any profits will be subject to capital gains tax. If crypto is used to purchase an NFT (and it usually is), the buyer is essentially cashing out their crypto to make the purchase, and is taxed accordingly.
Growing interest in crypto
Although tax law for crypto is still evolving and will likely continue to do so, the IRS has issued a fairly extensive list of FAQs to answer most questions pertaining to the 2022 tax year. For individuals who have done even a modest amount of crypto trading, however, the ins and outs of evolving crypto tax law might appear daunting.
CPAs should be aware of this opportunity. Certainly, CPAs with a deeper understanding of crypto can use this time to differentiate themselves in the minds of crypto traders. Amateur traders, those trading crypto professionally, or even those building a business based around crypto—all could likely use professional help in the weeks and years to come.