Cryptocurrency: Tax Basics and Income Considerations
May 5, 2022 - Publication
Cryptocurrency and other digital assets such as nonfungible tokens often feel like an unexplored universe, where the laws of nature haven’t yet been discovered. Where the system that is being developed, and the rules that will govern, have the potential to upend the current economic structure. As that monumental shift continues to grow, and current rules, such as existing tax law, are being applied to digital assets, certified public accountants, tax attorneys, and enrolled agents are acquiring the skills and experience necessary to assist cryptocurrency holders with their tax compliance requirements. Some advisors are even navigating the sparse but developing IRS rules and notices to provide planning advice and tax management strategies. While it is key to have knowledgeable advisors helping you manage your tax responsibility, it is also helpful for the cryptocurrency owners and investors themselves to have a basic understanding of the following ways in which their cryptocurrency transactions may generate a tax bill.
The federal government currently considers cryptocurrency to be a form of property, rather than currency. As a result, certain transactions, such as making a payment using cryptocurrency or exchanging one type of cryptocurrency for another, might actually generate an income tax liability. Some potential income recognition events include the following:
Receiving cryptocurrency as payment for goods or services: A recipient is taxed on the value of the crypto that such recipient receives as payment for selling goods or performing services. The taxable amount is based on the value of the coin at the time it is received. Cryptocurrency values continue to fluctuate dramatically, so it’s possible that by the time the recipient’s tax payment is due, the coin has decreased in value to where it’s worth less than the tax that’s due on it. It is therefore important to set aside sufficient cash in US dollars to pay income tax on cryptocurrency that is received as payment for goods or services. In addition to being subject to income tax, the value of the coin received as payment may be subject to self-employment tax if the payment is connected to a trade or business.
Exchanging one coin for another: Since crypto is considered property, trading one type of coin for another is considered a taxable event. The trader is deemed to have “sold” his or her initial coin, and the taxable gain will be based on the difference between the value of the coin at time of exchange and the trader’s tax basis in that coin. In general, tax basis is the amount originally paid for the coin, and/or the initial amount of income that was picked up when it was received for goods or services. Similarly, exchanging crypto for US dollars can generate a taxable gain.
Making payments using cryptocurrency: Similar to the results of exchanging a coin, using crypto to make a payment for goods or services is treated as if the crypto had been sold at the time of payment. Again, tax will be due on the difference between the fair market value of the coin at the time it was spent vs the owner’s tax basis in the coin.
Mining cryptocurrency: Crypto that is generated by mining activity is also subject to tax, based on the fair market value of the coins received.
REPORTING AND PAYING TAX:
The reporting systems are not currently as robust for cryptocurrency exchanges as they are for traditional financial products such as stocks, bonds, and non-crypto banks and brokerages. So crypto owners may not receive the necessary data and reports from a crypto exchange to calculate and report their tax liability, but the federal government will still be expecting them to report their crypto-related income and pay the appropriate taxes.
Ordinary Income vs Capital Gain: Income resulting from capital gain, such as from the sale of crypto or exchanging one coin for another, is taxed at a lower rate than ordinary income – if the capital gain is long-term. To qualify as long-term gain, the crypto must be held by the taxpayer for more than one year. Currently, the maximum federal rate on long-term capital gain is 20% (plus a potential 3.8% additional tax). If the crypto is held for one year or less, the gain on sale is considered short-term and is taxed at the ordinary income rate of up to 37%. Receiving crypto as payment for goods or services, or from mining, will likely be considered ordinary income and subject to the higher tax rate.
Reports from Exchanges: As reporting rules continue to expand to cover crypto exchanges and brokerages, crypto owners will begin to receive certain tax reports that report information such as sales of crypto or interest earned on investments. A common reporting form is 1099-B which shows gross proceeds from crypto transactions during the year. The IRS is also provided with the amounts on form 1099-B, and it will attempt to match the proceeds shown on the form to the amount reported on the recipient’s income tax return. Sometimes the 1099-B will also include the tax basis of crypto that was sold or exchanged, which is necessary for computing the taxable gain. However, it is more likely for now that exchanges will not provide a tax basis report, so crypto owners will need to rely on their own basis records to ensure that they report the proper amount of income on their tax returns.
Liquidity: The IRS does not currently accept payment in cryptocurrency, which means crypto owners must have access to US dollars to pay their taxes. This may require converting some of their crypto to dollars, which may not always be ideal given the volatility of crypto values. As mentioned above, it’s possible that an owner may not be able to convert certain crypto to enough US dollars to pay the tax owed on the prior year’s taxable exchange. An awareness of the possible tax effects before initiating crypto transactions can help owners manage or avoid such unfortunate situations.
OTHER REPORTING REQUIRMENTS:
Government oversight of the crypto market is likely to expand. For example, President Biden’s recent budget proposal would require US financial institutions to report information on foreign owners of cryptocurrency, to be shared with those owners’ countries of domicile. The President’s administration hopes that this information sharing will encourage other countries to similarly report information about US citizens holding crypto in foreign accounts, for the IRS’s use in tax collection and enforcement. Another Biden budget proposal would require individuals holding crypto in foreign wallets to file an annual form 8938 and report such holdings.
Tax Return Disclosure: The current version of form 1040 (the tax return for US individuals) has a question on page 1 that must be answered by all filers. The question, prominently displayed before any income numbers are reported, simply asks, “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” If a crypto owner has his or her tax return prepared by a professional, the owner must be sure to give the preparer sufficient information to accurately answer this question, and to account for any reportable income from the cryptocurrency.
Foreign Reporting: There are onerous penalties for failing to disclose certain foreign holdings. A tax adviser should be consulted to determine if you should be filing certain disclosure forms such as the FBAR or form 8938.
This overview regarding the taxation of cryptocurrency is intended to help crypto owners intelligently and confidently report their crypto transactions or seek appropriate guidance from a professional. For legal or tax advice on a specific cryptocurrency matter, please contact Levun, Goodman & Cohen, LLP.