Mainstream interest in receiving and trading cryptocurrencies has proliferated among individuals and corporations. This article reviews what we know regarding the tax treatment of crypto so far, examines current proposals, and offers expert insight on common questions.
This new digital space can be intimidating for the uninitiated and just as confusing for those who hold or plan to trade cryptocurrency. There is a demand for crypto assistance that can “help explain to folks what is this and what’s happening” so they can make informed decisions, Julio Jimenez, a principal at Marks Paneth, told Checkpoint in an interview.
Timeline of guidance and rules. The IRS first established its position eight years ago in Notice 2014-21, defining virtual currency as a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Expanded FAQs were eventually released in 2019 clarifying that a cryptocurrency is a type of virtual currency that “uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.”
So-called stablecoins, or “convertible virtual currencies,” like Bitcoin have an equivalent value in fiat currency. At the time of writing, for instance, one Bitcoin is worth over $39,000. However, despite the implication of the word “currency,” the key takeaway from the IRS notice is that for federal tax purposes, virtual currencies are considered property, to which general tax principles for property transactions apply.
This means that a taxpayer may realize a gain subject to capital gains tax in various transactions, such as selling cryptocurrency for cash, paying for goods and services, or exchanging a form of cryptocurrency for another (like-kind exchange rules don’t apply). Like other capital assets, the tax rate depends on how long the cryptocurrency is held.
Short-term capital gains apply to transactions involving assets held less than a year and are taxed at the same rate as ordinary income. Long-term capital gains are subject to rates of either 0%, 15%, or 20%, depending on income and filing status. Cryptocurrency holding periods begin the day after the asset is received. The fair market value of cryptocurrency is determined at the time of receipt.
As an example, assume a taxpayer buys one Bitcoin worth $30,000. The initial transaction is not a taxable event. The taxpayer has an annual income of $100,000. Six months after acquiring that Bitcoin, they exchange it for U.S. dollars when it’s valued at $40,000. In this scenario, the taxpayer recognizes a $10,000 gain subject to short-term capital gains tax at their income tax rate. Using current tax brackets, the $10,000 would be taxed at 24%. Conversely, if the Bitcoin is exchanged 18 months later and is valued at $40,000, the $10,000 gain would be taxed at 15%.
For compliance purposes, tracking the original cost basis for denominations of cryptocurrency is vital. The IRS recommends having records of each “unit” as described in the FAQs, including the date and time acquired, and the fair market value at the time.
What about nonfungible tokens (NFTs)? These are unique digital assets derived from blockchain technology that can take various forms, such as artwork, music, or in-game items. Although their purpose and function are distinct from a “currency,” tax treatment rules for purchasing an NFT are similar.
“The act of buying an NFT, just like buying any asset, does not by itself create a taxable event. Whether buying an NFT is a taxable event depends on the medium of exchange used to purchase,” Trudie Kanter, a partner in the tax services group at Crowe, told Checkpoint.
“If using cash … there is no taxable event,” she said. “If using a digital asset to purchase the NFT, there could be a taxable event because the purchase using the digital asset is treated as a disposition of such asset, which could generate taxable gain or loss.”
For more NFT tax coverage, see NFTs Add New Wrinkle to Crypto Tax Confusion, Experts Say.
Ordinary income events. Jimenez explained that while he gets many questions from clients that are “intrinsic” to the nature of digital assets such as cryptocurrency, the most frequently asked-about tax matter is: What events result in a taxpayer receiving ordinary taxable income as opposed to an asset subject to capital gains tax?
If someone receives cryptocurrency as a result of a transaction, the fair market value is treated as ordinary income. Also, if someone uses computer resources to validate transactions on the blockchain in a process known as “mining” and receives a cryptocurrency reward as a result, the miner includes the value of the reward at the time it’s received in their gross income.
Rev Rul 2019-24 clarified two situations where a taxpayer may have gross income. A “hard fork” occurs when a cryptocurrency’s code changes and results in a split, with one branch following the old protocol while the other branch follows the new one. Users upgrade their software as a new currency is created.
The bottom line for tax purposes is that if a hard fork occurs on a cryptocurrency a taxpayer owns, they only have gross income if they receive units of a new cryptocurrency. The same is true for “airdrops” of new cryptocurrencies following a hard fork. An airdrop, the IRS explained, “is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.”
Owners of multiple crypto “wallets”—where a taxpayer’s cryptocurrencies are digitally stored—should note that transfers between wallets aren’t taxable events, as no assets are transacted with another party.
The $15,000 gift tax annual limit also applies to gifts of crypto, meaning total gift amounts in a year under that threshold aren’t subject to gift tax.
New reporting rules for brokers. The most recent major cyrpto development was the Infrastructure Investment and Jobs Act (IIJA; PL 117-58) signed into law November 15, 2021, which featured two provisions affecting the crypto marketplace. First, Code Sec. 6045 was modified to now require brokers, or anyone “responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person,” to report digital asset transactions on Form 1099-B in a way similar to some securities. Reported details include sale proceeds, basis, and dates. The Act defines a “digital asset” as any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology.
Further, crypto transactions in excess of $10,000 must be reported on Form 8300, and digital assets are treated like cash. These reporting changes take effect for applicable transactions occurring after January 1, 2023, and for reports due after December 31, 2023. See Executive Summary: Infrastructure Investment and Jobs Act. See also Client Letter: IIJA New Digital Asset Info Reporting, a sample client letter breaking down these provisions.
State-level treatment. Analysis of how individual states have or haven’t taken positions on the tax treatment of virtual currencies is beyond the scope of this article, but Checkpoint has up-to-date information on corporate income, personal income, and sales and use tax considerations for all 50 states and Washington, D.C. For reference, use Checkpoint’s state chart generation function to filter what you want to know.
Here is the full breakdown as of April 28, 2022.
A note on terminology. It can be easy to use terms from the crypto glossary interchangeably, but the distinction between specific words is becoming increasingly relevant despite their overlap in meaning. With the timeline of developments from the initial 2014 notice through the infrastructure bill now reviewed, let’s recap the nomenclature before moving on to future considerations.
As noted above, President Joe Biden’s administration has been using the definition of digital asset to encapsulate both fungible and non-fungible digital assets, such as cryptocurrencies (a type of virtual currency) and NFTs (a specific piece of content that isn’t “spent” like money).
Cryptocurrencies include stablecoins like Bitcoin that are convertible to fiat currency and what are known as utility tokens that are treated as equity in a partnership. Further, security tokens are considered ownership of a stock or security. The difference between a coin and a token in this context is that tokens don’t have their own native blockchain.
“To date, the IRS has painted a very broad brush by characterizing all cryptocurrencies as property for tax purposes, without making any distinction between different types of cryptocurrencies,” a team of tax professionals at Greenberg Traurig told Checkpoint in comments curated by shareholder Pallav Raghuvanshi.
For more on the nuances between these terms, see ABA tax meeting: Why words matter when taxing crypto.
Current administration’s policies. Following the passage of the infrastructure bill, the Biden administration has taken steps indicating that compliance enforcement, new regulatory authority, and risk assessment will be key areas of focus moving forward.
On March 9, the president signed an executive order laying out his digital asset plan, calling for more oversight over cybersecurity and bad actors by effectively centralizing the digital asset world. This begins with a review of a potential Central Bank Digital Currency (CBDC). Biden instructed a concert of top agency officials to, within 180 days, submit a report on “the future of money and payment systems.”
Such a sweeping review will examine digital payment technologies, the interplay of related market forces, and the effect of modernization to the U.S. economy. For more, see President Biden signs Executive Order on digital assets. The executive order can be seen as the beginning of a campaign to crack down on digital asset-related schemes and other white-collar crimes, or at the very least an acknowledgement that crypto is likely not going anywhere anytime soon. The value of Bitcoin rose after this move, though the volatile cryptocurrency is prone to massive fluctuation.
Later in March, the administration released this year’s “Green Book,” which serves as a platform for outlining budget proposals for the next fiscal year. Biden’s fiscal 2023 agenda includes a trio of modernization-themed rule changes to accommodate digital assets. The first has to do with crypto lending and would provide that securities loan nonrecognition rules apply to loans of actively traded digital assets recorded on cryptographically secured distributed ledgers if the loan terms are similar enough to securities loans.
The Green Book argued that the recent growth in digital asset trading justifies this expansion, and that “taxpayers should be required to take income accruing on the asset into account as they would do absent the loan.” The proposal, which would take effect for returns filed starting 2024, would give the secretary of the Treasury the authority to determine when a digital asset is actively traded and potentially later apply the rules to non-actively traded digital assets.
The next two proposals would take Biden’s digital asset compliance efforts to the international stage via the Foreign Account Tax Compliance Act (FATCA). One proposal would create a new reporting requirement category under Code Sec. 6038D(b). Taxpayers in the U.S. holding an aggregate value of over $50,000 in cryptocurrency and related digital assets in a “foreign digital asset account” would report this information to the IRS. This would crack down on tax avoidance behavior by crypto investors and apply to returns filed after December 31, 2022.
“The global nature of the digital asset market offers opportunities for U.S. taxpayers to conceal assets and taxable income by using offshore digital asset exchanges and wallet providers,” according to the Green Book. For more on the proposed rules, see Treasury Eyes New Reporting Rules for Foreign Digital Assets.
Finally, the Green Book suggests that the U.S. would bolster its automatic information sharing with other countries. Specifically, U.S. digital asset exchanges would have to disclose information on substantial foreign owners of some passive entities. Certain financial institutions would also need to report the account balance “for all financial accounts maintained at a U.S. office and held by foreign persons.” This includes digital asset brokers, likely under the definition provided by the infrastructure bill. The proposal would be integrated with existing law and be effective for returns filed beginning 2024.
The Wild West that is the current state of digital asset trading has attracted investors with a promise of decentralization, unburdened by regulation or red tape. Depending on whom you ask, the Biden team’s position could either be seen as a vehicle to bringing legitimacy to this adolescent space, or big government sticking its nose where it doesn’t belong and crashing the party. The IRS, naturally, is motivated by capturing revenue from unreported transactions and closing the so-called tax gap. Many investors simply want to know what is expected of them to avoid audit, according to Jimenez.
The need for guidance. To say that there is an appetite among practitioners and their clients for more guidance would be a gross understatement. The IRS has been slow on the uptake to keep up with cryptocurrencies and how the technology is used. While the agency often directs most questions to their existing guidance, particularly the FAQs, there has been a deluge of speculation on how specific crypto situations could be treated on the tax end.
New questions arise by the day as individuals and corporations find roadblocks where there is no reliable answer from the federal government. “The blockchain world is evolving at a breakneck pace, and there are many areas in which the IRS has yet to provide specific guidance,” Raghuvanshi and the Greenberg Traurig team said.
Although it would be an impossible task to identify everything we don’t know, some questions are squarely in the minds of lawmakers and industry experts. The following are some examples of pressing hot button crypto issues.
Who is a broker? At the time of writing, there have been no proposed regs following the enactment of the infrastructure bill to clarify the definition of a broker as it pertains to those who deal in cryptocurrency. Depending on interpretation, the expanded definition under this new statute that will take effect next year could apply to considerably more parties than perhaps initially intended by lawmakers. The IRS could ease the minds of many taxpayers with guidance just on this point alone.
Last December, a bipartisan group of senators wrote a letter addressed to Treasury Secretary Janet Yellen asking for clarification on to whom the provision applies. As enacted, it could technically “capture certain individuals who are solely involved with validating distributed ledger transactions through mining, staking, or other methods, and entities solely providing software or hardware solutions enabling users to maintain custody of their own digital asset wallets,” the letter read.
Given the slim party margin in the Senate, new laws governing crypto—especially those wrapped up in larger packages—face an uphill battle to reach the president’s desk. Jimenez said “everyone was shocked to the core” when the digital asset reporting requirements survived in the infrastructure bill’s final version. It seemed a sure thing that if there was something that would be carved out, it would be that, according to Jimenez.
The private crypto lobby was “pushing last minute talking to the Senate. Everyone thought this was going to get yanked out. It didn’t,” he said. In light of that unexpected development, regulations on who is a broker is necessary “so that we know how [Form] 1099 and U.S. payment reporting works.”
Income sourcing and staking. Determining the source of income and which jurisdiction has authority to impose tax is tricky, especially for transactions involving multiple countries.
A team of Skadden Arps lawyers wrote in January in a post on the firm’s site that this “is particularly difficult in a world of the distributed ledger,” which makes finding a solution “critical to establishing the existence of branches or permanent establishments under tax treaties.” The global tax community will need to address this as more countries hitch their wagon to the Organization for Economic Cooperation and Development’s two-pillar model. Differences in income-sourcing laws between nations is complicated enough without factoring in tax treatment of digital assets. Meanwhile, El Salvador adopted Bitcoin as legal tender in September 2021. The Central African Republic followed suit in April this year.
Another unanswered and consequential matter is the treatment of income from what is known as “proof of stake,” a cryptocurrency consensus mechanism for validating blocks on the blockchain. The goal of proof-of-stake is to reduce the negative impacts on the environment from the traditional mining process, whereby an individual with multiple dedicated computers can consume enormous amounts of energy by trying to gain as many token rewards as possible. This is done by using an algorithm for determining an individual’s ability to mine after they “stake” their own cryptocurrency.
This is the core issue at Jarett v. U.S., ongoing litigation that could shed light on whether staking rewards are taxed the same as new cryptocurrency received from typical mining. Taxpayers Joshua and Jessica Jarrett reported stake rewards as “other income” on their 2019 return but later filed an amended return to reflect that the rewards weren’t taxable income. The IRS offered a refund check to resolve the overpayments, but the Jarretts contend that a single refund doesn’t set a sufficient precedent for other blockchain validators.
The Greenberg Traurig team said that “while the IRS specifically treats cryptocurrency mining as a taxable transaction, it isn’t entirely clear how staking income would be taxed” absent a definitive close to Jarrett. The IRS filed a motion to dismiss for lack of jurisdiction, arguing that their refund settlement offer should suffice. The case is before the U.S. District Court for the Middle District of Tennessee.
Wage payments in crypto. There has been increasing interest, especially among younger employees, in receiving wages in the form of cryptocurrencies because of its potential for future profit. Last November, Nasdaq analyzed the findings of a poll conducted by deVere Group. Of those born after 1996, 51% reported that they “would be happy to receive 50% of their salary” in cryptocurrency, according to the survey.
This prompts the question as to whether such arrangements are even possible under current law. The answer may depend on which government agency you ask. The Labor Department’s response to a Checkpoint query on whether cryptocurrencies are viable employee compensation pointed to a regulation under the Fair Labor Standards Act providing that wage payments may be “made in cash or negotiable instrument payable at par.” The department declined to comment further when asked if this included cryptocurrencies.
The IRS supplied a more direct answer, telling Checkpoint that, generally, “employers may choose to pay employees in cryptocurrencies.” This is backed up by the answer given to Q11 in the aforementioned 2019 FAQs. For employment tax purposes, “the medium in which renumeration for services is paid is immaterial.” For more on crypto wage payments and agency responses, see Can Employers Pay Wages in Cryptocurrency?
Security or commodity? In recent years, there has been ongoing discussion and a desire for clarification on whether cryptocurrencies should be categorized as commodities or securities (or neither) for federal income tax purposes. Ultimately, this would affect which government agency has regulatory authority. If cryptocurrencies are treated as securities like stocks or bonds, the Securities and Exchange Commission would apply laws under the Securities Act of 1933.
Alternatively, the Commodity Futures Trading Commission could treat cryptocurrencies as a form of good, more akin to oil or metals pursuant to the Commodity Exchange Act of 1936. Reuters recently reported on how the SEC uses the so-called Howey Test to determine whether an asset is an “investment contract” and thus a security.
On April 18, the New York State Bar Association Tax Section submitted a report to top officials at the Treasury Department requesting guidance on the security/commodity issue with respect to cryptocurrencies as well as to other fungible digital assets.
“The desire for guidance on the tax treatment of digital assets is significant and extends to a multitude of tax provisions,” the report said. “However, the diversity of digital assets, and the rapid pace at which new digital assets are being developed, makes providing a comprehensive set of recommendations to address all or even most of the significant issues affecting digital assets unrealistic.”
Among the NYSBA’s recommendations were to apply Code Sec. 864(b)(2)(B) commodities trading safe harbor rules to cryptocurrency and to allow Code Sec. 475 market-to-market elections for cryptocurrencies only if they qualify as actively traded property as described by Code Sec. 1092(d)(1), assuming the CFTC has jurisdiction.
Advice for investors. Taxpayers should “generally start with the presumption that any transaction involving cryptocurrency would be a taxable event unless certain specific exceptions apply,” according to Greenberg Traurig. Bear in mind that while guidance is sparse, it behooves taxpayers to pick up on signals sent by lawmakers and federal agencies on which way the wind is blowing. At the same time, investors needn’t panic in response to every proposal.
Online trading platforms that operate as crypto exchanges have become more commonplace. “To the extent you use software to keep track of your digital asset transactions, it is imperative to review the reports and transactional-level details to verify the proceeds, cost basis and holding period,” Crowe’s Kanter said. “In addition, we urge clients to remain consistent with the cost basis methods (FIFO vs. Specific Identification), and to the extent they do switch software, make sure the variances in gains and losses in prior years are reviewed.”
This tax season asked filers for the first time about their crypto footprint: “At any time during 2021, did you receive, sell, exchange or otherwise dispose of any virtual currency?” If you expect to answer “yes” next year, work with your preparer “so that you just don’t do something blindly and then end up in a regrettable position,” Jimenez said.
Christopher Wood contributed to this article.
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