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WOLF & CO Alerts Lessons Learned from Busy Season: Cryptocurrency and Digital Assets

Lessons Learned from Busy Season: Cryptocurrency and Digital Assets

Written by: Jonathan Whittaker, CPA & Cody D. Belland, CPA, JD

In 2014, the IRS issued Notice 2014-21 addressing virtual currency, virtual currency transactions, and related tax implications. Since then, the market for virtual currencies (cryptocurrencies) has experienced tremendous growth with the largest cryptocurrency, Bitcoin, reaching a market capitalization of $1 Trillion dollars in 2021. As the IRS works to provide further guidance on the tax treatment of this exponentially growing market, Wolf & Company P.C. has been actively tracking IRS developments and current market practices. Below we’ll discuss some lessons learned from the 2020 tax compliance season for individuals investing in cryptocurrencies or for individuals who are interested in learning more about this new and exciting market.

Lessons Learned and Frequently Asked Questions:

Please note that the below scenarios and tax treatments are subject to change as additional guidance is issued at the federal and state level.

What types of events should I disclose to my tax advisor?

  • Taxpayers should be mindful of and inform their tax preparer/advisor if they had any of the below events occur during the calendar year as they relate to cryptocurrency or other digital asset investments:
    • Purchases & Sales of cryptocurrency and other digital assets
    • Air Drops
    • Charitable Donations
    • Cryptocurrency received as compensation
    • Cryptocurrency received as Gifts
    • Hard Forks
    • Mining Income
    • Staking / Interest Income
    • Rewards
    • Receipt of cryptocurrency due to coin swap/migration

How is cryptocurrency treated for Federal Income tax purposes?

  • For federal tax purposes cryptocurrency is treated as property and general tax principles applicable to property transactions apply. Like property, taxpayers should be mindful and keep detailed records when purchasing, receiving, selling, or exchanging cryptocurrencies for other property or services. To determine the cost basis of a cryptocurrency investment, taxpayers should track the amount in U.S. dollars spent to acquire the cryptocurrency including fees, commissions, and other acquisition costs. Each cryptocurrency purchase should be tracked separately and when exchanged or sold, cost basis must be assigned to the disposed asset using a consistent method. Selling or exchanging cryptocurrency triggers capital gains or losses. Acquisition dates should be tracked when determining short or long-term capital treatment.

How are cryptocurrency investments disclosed to the IRS?

  • The IRS added a question on Page 1 of Form 1040 asking the following: At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?

Would cryptocurrency received in exchange for performing services be included in gross income? What if that cryptocurrency is later disposed or exchanged?

  • When a taxpayer receives cryptocurrency in exchange for performing services the taxpayer would recognize ordinary income at the fair market value of the cryptocurrency at the date the cryptocurrency is received by the taxpayer. The taxpayer’s basis in the cryptocurrency would be equal to the amount of gross income (fair market value) included on the taxpayer’s return on receipt of the cryptocurrency. If the cryptocurrency is later sold for U.S. dollars or exchanged for other property (including other cryptocurrencies) capital gains/losses would be calculated similar to a disposition of other property.

If I pay for services using cryptocurrency does it trigger a taxable event?

  • Like property, the taxpayer would calculate their capital gain or loss as the difference between the fair market value of the services received and their adjusted tax basis in the cryptocurrency.

If I receive, sell, or exchange property for cryptocurrency, do I recognize capital gains or ordinary income?

  • If the taxpayer transfers property held as a capital asset in exchange for cryptocurrency the exchange may be subject to the beneficial capital gains tax rates. If the property exchanged is not a capital asset, then ordinary gain or loss would be recognized by the taxpayer. An example of a capital asset would be an investment asset that is not intended for sale in the regular course of business operations.

How would cryptocurrencies received through mining be treated for federal income tax purposes?

  • If the taxpayer’s mining constitutes a trade or business and the mining activity is not undertaken as an employee, cryptocurrency earned through mining would be treated as ordinary income and would be included in gross income when determining self-employment income and self-employment tax. The amount included in gross income would be equal to the fair market value of the cryptocurrency at time of receipt.

What are NFTs and how are they treated for federal income tax purposes?

  • Non-fungible tokens (NFTs) are digital assets that are units of data stored on a blockchain. The IRS has yet to issue any NFT specific tax guidance, but current market practices have indicated two scenarios taxpayers should take into consideration. If a taxpayer creates an NFT and offers it for sale, the taxpayer will trigger a taxable event when the NFT is sold. Proceeds received from the sale of the NFT would be included in ordinary income and subject to self-employment taxes. If a taxpayer buys and sells NFTs for speculative purposes they would trigger capital gains tax. NFTs could be considered collectibles so high-net-worth individuals may be subject to the highest 28% tax rate on collectibles.

Are there any opportunities for tax planning with cryptocurrencies or other digital assets?

  • Yes! There are several tax planning strategies that can be utilized. A few examples include:
  • Charitable donations: If a taxpayer has philanthropic inclinations, they could consider donating appreciated cryptocurrency (or other digital assets) to charitable organizations. Just like with appreciated stock, the taxpayer could receive a deduction for the fair market value of the assets donated, without recognizing the gain on the asset’s appreciation. It is important to note that, like with other non-cash charitable contributions, the IRS may require certain substantiation (e.g., receipt, acknowledgment letter) in order to receive the deduction.
  • Retirement Accounts: There may be opportunities to hold cryptocurrency (or other digital assets) in tax sheltered retirement accounts such as Roth IRAs. As the IRS issues additional guidance related to cryptocurrency and digital assets, taxpayers should discuss with their tax preparer/advisor what tax planning opportunities are available.

Closing Remarks

As the market for cryptocurrency and other digital assets continues to expand, the IRS and state government agencies are continuing to work on and issue guidance as it relates to the tax treatment of these new “assets”. Some items to look out for in future IRS guidance include potential wash sale treatment, Form 1099 disclosure requirements, charitable donations, and inclusion in tax deferred accounts such as Roth IRAs. Individuals investing in cryptocurrencies and other digital assets, as well as tax preparers and advisors preparing returns on behalf of individuals with cryptocurrency or digital asset investments, have more responsibility than ever to ensure they are reporting these transactions accurately and thoroughly. It is essential that individuals and tax advisors keep detailed records regarding cryptocurrency and digital asset transactions. The current market for cryptocurrencies and other digital assets is volatile and there are inherent risks when investing in these emerging assets. This alert should not be used as investment advice and individuals interested in investing in cryptocurrencies and other digital assets should discuss with their financial advisors.

Wolf & Company, P.C. is closely following the market trends in the cryptocurrency and digital asset environment as well as relevant legislation and guidance at the federal and state level. If you are a taxpayer or tax preparer/advisor who have questions related to the above topics please reach out to the contacts below and we’d be happy to discuss you or your clients’ needs:

 

KRISTIN L. STONE, CPA, MST
Principal
Wolf & Company, P.C.
255 State Street, Boston, MA 02109
Direct +1 (617) 428-5464
[email protected]

RYAN P. BRUNELL, CPA, MST
Principal
Wolf & Company, P.C.
255 State Street, Boston, MA 02109
Direct +1 (617) 933-3348
[email protected]

JONATHAN WHITTAKER, CPA
Tax Manager
Wolf & Company, P.C.
255 State Street, Boston, MA 02109
Direct +(617) 419-4246
[email protected]

CODY D. BELLAND, CPA, JD
Tax Manager
Wolf & Company, P.C.
255 State Street, Boston, MA 02109
Direct +(617) 261-8140
[email protected]