Crypto prices are notoriously volatile. In considering such variability, clients wonder about the tax implications of their cryptocurrency holdings. This article will provide you with a high-level overview, as well as some potential tax benefits, of trading cryptocurrencies in a bear market.
Cryptocurrency taxation should be simple. When assets are purchased, they have a tax basis. When they are sold, the difference between that tax basis and the proceeds becomes your gain or loss. The IRS has provided guidance that cryptocurrencies should be treated as “property,” meaning that the sale or exchange generally results in capital gains.
Tracking Tax Activity
Unfortunately, the reality is that cryptocurrency transaction reporting is far from simple. US based exchanges (like Coinbase) have only recently started to provide gain/loss reports for tax purposes. Many exchanges provide only data exports, and decentralized exchanges provide no reporting at all. This is the equivalent to trading via a broker such as E*TRADE, then receiving no substantiation at the end of the year as to what happened. Can you imagine a situation in which you received no Form 1099? Where might you find a breakdown of the taxable income?
In the simplest cryptocurrency reporting situation, a client who trades exclusively on a US based exchange, like Coinbase, can generate a “Gain/Loss Report” from the Tax Center. If they have only ever transacted on this exchange, this report may be all that is required for their US tax reporting purposes.
When a client uses multiple exchanges, or has experimented with NFTs or DeFi, reporting becomes significantly more complicated. In this situation, most clients will need to employ the use of a third-party software, like CoinTracker, TokenTax, or Coinlist. These paid software tools will aggregate data across different wallets, layer one blockchains, tokens, and more to provide a holistic picture of any gain, loss, and other income generated. When using one of these software tools, it is important to include every wallet address and detail since the first time they have interacted with cryptocurrency. Unfortunately, no one software produces a perfect report with minimal input from the taxpayer. Manual entries and adjustments are almost always required, and some software tools may be a better match for some clients according to their activity.
What is Taxable?
Cryptocurrencies can be taxed in a variety of ways. When you earn cryptocurrencies for a service or activity, they may be taxable as ordinary or self-employment income. If you sell a cryptocurrency or exchange one for another, your earnings may be taxable as capital gains. If you transfer virtual currency from a wallet, address, or account belonging to you, to another wallet, address, or account that also belongs to you, then the transfer is a non-taxable event, even if you receive an information return from an exchange or platform as a result of the transfer. Unfortunately, the IRS has released limited guidance on what it explicitly considers taxable in the cryptocurrency area and has not provided any updated guidance since 2019. In that time, many new cryptocurrency technologies have leapt forward: NFTs, wrapped tokens, cross-chain interoperability, DeFi, and countless others. You may need to discuss unique situations with your tax advisor if you are unsure of how your crypto gains and losses will be treated for tax purposes. The most conservative approach, however, is that if you have sold crypto, exchanged it for another coin/token, or received it as compensation, be prepared for a related tax hit.
New Developments: Digital Asset Question on Form 1040
The IRS wants to ensure crypto reporting compliance, and, as your tax preparer, we now have to inform them on every tax return about digital currency transactions. The question reads: “At any time during 2023, did you: (a) receive (as a reward, award or payment for property or services); or (b) sell, exchange, gift or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”. Please note that this question requires an assessment and response every year, not just when there is taxable income from a transaction.
New Developments: Staking Taxation
IRS Revenue ruling 2023-14 states that rewards from cryptocurrency staking must be included in a taxpayer’s gross income when they have the ability to sell, exchange, or otherwise dispose of the reward. In other words, when they have dominion and control of the reward. This reinforces the IRS position that cryptocurrency is not “self-created property”, which is taxable only upon disposition. Staking reward reported as income in the year where dominion and control are realized will then treat this as the tax basis of the cryptocurrency for future sales.
Tax Tips: Wash Sales
Cryptocurrencies are considered property by IRS standards, as opposed to securities. This unique categorization has a powerful tax planning aspect associated with it. When securities decline in value, “wash sale” rules limit a taxpayer’s ability to sell and immediately repurchase that asset to realize a tax loss, while still maintaining ownership of the same or similar security. These rules were established to prevent traders from generating tax losses while maintaining the same economic position. Property (and therefore, cryptocurrency) is not subject to the same wash sale rule. This means that either upon market decline or at the end of the year as part of tax planning, a taxpayer can “free up” tax losses on cryptocurrencies to offset other sources of gain, but still hold those assets if they are optimistic about future returns. The wash sale rules may change in the future, but no legislation has been finalized yet.
Tax Tips: Charitable Donations
Like other appreciated assets, cryptocurrency can be donated to charities at the fair market value at the time of transfer. Donating long term appreciated assets to charity is a very effective tax planning tool as it allows you to donate “pre-tax dollars” as opposed to “post-tax dollars” like cash. The difference is roughly a 20% tax savings. However, if a donation is made, IRS Notice 20230212 specifies that a qualified appraisal of the assets is required; you cannot base the deduction on the exchange trading value at the time of transfer.
Tax Tips: Gas and Transaction Fees
Another commonly missed adjustment is the gas fee associated with blockchains like Ethereum. Every time a transaction is sent, gas in the form of ETH must be spent to fuel the transaction. Sometimes these fees are small per transaction, but they have been known to vary significantly. You may be able to increase your basis in investments by reporting these gas fees, therefore reducing any potential gain. Some software tools track this independently, while some may require a manual approach. If you had a significant number of transactions during the year, we would encourage you to discuss gas fees with the manager or partner on your account.
Confused?
Crypto tax and accounting is a new and developing field. We know it’s frustrating, and we will do everything we can to assist as much as possible. Our firm is committed to helping you navigate, and potentially benefit from, all of the tools available to us.
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