As of the date of publication, the global value of cryptocurrency is hovering near $2 trillion, a 700 percent increase from the same time a year ago. The rapid increase is attributed to many factors, not the least of which are corporate and financial institutions’ interest, as well as Tesla CEO Elon Musk’s $1.5 billion cryptocurrency purchase in February 2021. Though Tesla decided to pause its plan of accepting bitcoin as payment, it is this type of interest above and beyond fractional crypto investors that is paving the way for long-term cryptocurrency adoption – and increased regulatory attention.
The Current Cryptocurrency Craze
Bitcoin may be the most established, but it is far from the only cryptocurrency on the market. Dogecoin, originally created as a joke, has grown 10,000 percent in 2021. Other types of cryptocurrencies include ether, binance coin, cardano, tether, and XRP. Bitcoin has gained more widespread acceptance among financial institutions than most other types of cryptocurrencies; however, until it can be more easily used for everyday transactions, it may remain an outlier in the finance world.
Despite now being relegated more to derivatives trading, people are noticing. The White House, Federal Reserve, and SEC are calling for more regulation, while the IRS recently issued guidance on the tax treatment of certain cryptocurrency transactions.
Cryptocurrency Tax Basics
The IRS considers cryptocurrency a property, not currency. This means that crypto owners and investors in the U.S. must follow tax rules for capital gains, not income tax. Selling cryptocurrency would trigger either a short- or long-term capital gains liability depending on how long the asset was held. Remember, short-term capital gains are taxed at ordinary income tax rates up to the current high of 37-percent, while long-term capital gains are subject to a top rate of 23.8-percent (20-percent plus 3.8-percent net investment income tax).
Also, since crypto-to-crypto transactions are excluded from current tax law’s §1031 like-kind exchanges, any gain or loss must be recognized when the currencies are exchanged. It can become complicated to record the tax basis, gains, and losses of crypto-like-kind exchanges so investors must proceed with caution.
There are several issues at play when deciding what type of tax framework to assess a cryptocurrency transaction, including classification, timing, computational, and other issues. Answering questions like ‘are the crypto units currency, property, a financial asset, or intangible asset?’ while considering the effect of when the units were mined, stored, spent, exchanged, lost, stolen, and more. Further, issues like the taxable versus cost basis, valuation, capital gains, and de minimis rules must also be weighed against what type of transaction took place, like a fork for example.
Whether there is a taxable transaction with cryptocurrency may depend on whether the transaction is a soft fork or a hard fork. These are types of transactions, or events, and are common: bitcoin, for example, forked into bitcoin private, bitcoin gold, bitcoin diamond, and so on. Soft forks usually do not result in any income or new cryptocurrency, and the asset’s owner or holder is in the same relative position as before the transaction.
Hard forks are when a new form of cryptocurrency is created and continues to develop alongside the original or old version. Hard forks that are material are widely adopted by the cryptocurrency network. They can be either tax-neutral or taxable, depending on whether the holder receives new cryptocurrency units or if the transaction was an involuntary conversion.
An airdrop, when cryptocurrency units are distributed to multiple holders for free, is a method to promote a new type of cryptocurrency. These are marketing ploys. In the U.S., airdrops are treated as windfall gains and could qualify as taxable income. One of the only exceptions to this type of taxable event is if the taxpayer cannot control whether he or she receives an airdrop.
Non-fungible tokens, or NFTs, are like digital deeds to a piece of virtual property. Memes selling for thousands of dollars are one example of NFTs; audio files, artwork, and other virtual clips also qualify as NFTs. The NFT is secured and verified thanks to a custom identifier that functions like an original IP address, which is stored on a blockchain. Twitter’s very first tweet, which founder and CEO Jack Dorsey published, sold for $2.9 million.
NFTs are currently taxed as property, or capital gains, but are not heavily regulated – yet. Consider the following scenario:
A taxpayer has two ether (ETH), which is the second most popular digital currency after bitcoin. The two ETH was purchased more than a year ago when they were valued at around $200 each. Now, he used those two ETH to purchase digital artwork, or an NFT, valued at $4,000 – or two ETH. The taxpayer would report the difference – $4,000 – $400 – as a long-term capital gain because he held the asset longer than one year. If another taxpayer then buys the same NFT with crypto units that she only purchased six months ago, the transaction would be taxed as a short-term gain.
Creators of NFTs must currently report NFT-related income on Schedule C or the corresponding tax form for businesses (either Form 1120, 1120S, or 1065). Ordinary business expenses can still be deducted, and buyers can still deduct a charitable contribution, if, for example, they donate the proceeds to charity (as Jack Dorsey did).
NFT investors would report capital gains or losses related to NFTs on Form 8949 and Schedule D. In some cases, the NFT qualifies as a collectible.
Regardless of whether the crypto transaction involves an NFT or not, since reporting standards are still lax, there won’t be any automatically triggered 1099s. This is where taxpayers must be careful to record the details of every crypto transaction.
Current IRS Guidance
New on the 2020 Form 1040, taxpayers noticed a direct nod to the rise of cryptocurrency: a checkbox asking taxpayers to verify whether they “received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency.” After this addition, it will be difficult for taxpayers to claim that they did not know they had to report cryptocurrency transactions.
More recently, IRS Chief Counsel Advice 202114020 took a clear stance on the agency’s position on how hard forks are taxed. This is on top of 2019 guidance stating that cryptocurrency recipients from a hard fork and obtained from an airdrop are taxable. More than 10,000 taxpayers received letters from the IRS after they potentially did not report taxable income because of a bitcoin airdrop in 2017.
The IRS is asking Congress for legislative authority to regulate cryptocurrency transactions and require additional reporting; without it, the agency will have a harder time lessening the tax gap. The IRS’s position cites IRC §61(a)(3) which means in relevant part that, except otherwise provided, gross income includes all worldwide income from whatever source derived, including gains from dealings in property.
Potential Legislative Intervention
For its part, Congress has taken interest in stronger reporting standards for cryptocurrency. SEC Chair Gensler has been asked to provide a report detailing how his agency would reduce the risk of crypto transactions, protect investors, and help decide further Congressional action. And, the White House has proposed requiring business crypto transactions above $10,000 to be reported and taxed like regular income. Cracking down on crypto transactions is one way the Biden White House intends to fund part of the American Families Plan, which was enacted in March 2021.
Also, consider that President Biden has proposed increasing the capital gains rate for taxpayers earning more than $1 million annually. If passed, wealthy investors would be subject to additional taxes for crypto transactions.
The taxation of cryptocurrency remains a complex and challenging matter that is expected to evolve as more regulations are introduced. If you have recently invested in cryptocurrency, or are expecting to do so soon, and are concerned about the tax impact, Calvetti Ferguson can help.