Cryptocurrency has been making headlines since the launch of Bitcoin in 2009.
While many experts feel cryptocurrency is here to stay — and may grow even more in value in the coming years — it’s best to advise your clients to proceed with caution: acquiring, storing and taxing cryptocurrency is unlike anything we’ve encountered before. If done improperly, their
As a newer type of investment product, the rules for cryptocurrency taxation are far from settled — in fact, they change often and will continue to do so as the IRS gets its hands around it. In the last few weeks, the IRS changed the applicability of the wash sale rules to cryptocurrency, and
When advising your clients about investing in the crypto market,
Taxation
Although cryptocurrency once flew under the IRS’ radar, that is no longer the case. The agency has made great efforts to capture and tax cryptocurrency transactions in recent years, like partnering with TaxBit, a software that identifies cryptocurrency transactions.
The IRS ruled in 2014 that cryptocurrency is an investment in digital property (a capital asset), not a type of currency. As such, taxation rules generally follow the same rules we use for stocks or securities: taxation applies to any gain on the sale of the property; the gain is considered capital gain if held long-term and ordinary income if held short-term; losses on the sale of cryptocurrency can be used to offset other gain or taxable income; and interest earned in cryptocurrency accounts is considered ordinary income.
As of September 2021, cryptocurrency transactions are now subject to the wash sale rules, meaning losses on wash sales are no longer deductible,
However, there are some important differences between cryptocurrency and the traditional stock treatment that your client must be aware of:
- If the investor trades one type of cryptocurrency for another — for example, she uses Bitcoin to purchase Dogecoin — and the value of the Dogecoin acquired exceeds her basis in the Bitcoin, she has incurred a taxable gain on that transaction.
- Calculating the basis and gain on cryptocurrency transactions can become complex when different batches of cryptocurrency are acquired at different times. If the taxpayer has maintained detailed records on exactly when each cryptocurrency unit was acquired and sold, the basis, and the fair market value of the crypto and the asset it is exchanged for, then he/she can calculate the gain using specific identification (i.e., using each individual unit’s basis). However, the highest-in-first-out (HIFO) method is permitted if the taxpayer has maintained sufficient records. Crypto expert
Shehan Chandrasekara recommends HIFO since it utilizes the highest basis units first, therefore always resulting in the lowest realized gain. If the taxpayer doesn’t have the appropriate records, the LIFO method is the default practice. - If your client received cryptocurrency (e.g., from “mining” it on the blockchain, as a payment or gift or as part of a promotion), the value must be reported as taxable income.
- If the client pays for something with cryptocurrency, income tax is owed on the payment if the product or service received is of greater value than the cryptocurrency’s basis. For example, let’s say the taxpayer bought $30 of cryptocurrency and its value rises to $50 a few months later. The taxpayer then buys a shirt for $50 with the cryptocurrency. The taxpayer has realized $20 of gain on the transaction that must be reported as taxable income.
Tax reporting
The taxpayer is responsible for maintaining all records regarding cryptocurrency transactions. Some crypto platforms provide a 1099-K, but this only reports the total value of the transaction. The taxpayer must keep detailed records regarding the basis, time of the transaction, fair market value of the crypto and the asset received and report this information on Form 8849.
As of 2021, taxpayers must affirm if they sold, received, exchanged, disposed or acquired any financial interest in cryptocurrency on the Form 1040. Simply checking “yes” does not necessarily mean any tax will result. If the taxpayer acquired crypto before the calendar year and did not engage in any transactions during the calendar year, then the taxpayer may check “no.”
The average investor acquiring cryptocurrency as a personal investment must report income from cryptocurrency transactions on the Schedule 1; expenses related to crypto transactions are not deductible. However, if the client is engaged in cryptocurrency trading as a business, the normal Schedule C deductibility rules apply under section 162, including costs related to computing equipment and hardware, internet and storage. Any losses suffered due to scams or theft of cryptocurrency, which are unfortunately quite common, are not deductible.
Tax strategies
Of course, there are strategies clients can utilize to get the most out of cryptocurrency. One increasingly popular approach is
While taxes can be deferred or eliminated on the cryptocurrency’s growth, its volatility and the higher fees associated with these types of accounts make them suitable only as a part of a comprehensive strategy to diversify retirement income from several sources rather than the sole or primary source of retirement funds.
Chandrasekara also suggests donating appreciated crypto to qualified charities to avoid taxable gain or rolling over unrealized cryptocurrency gains into a qualified opportunity zone.
It’s an exciting time to be in the investment world — cryptocurrency is sure to change the financial landscape dramatically in the future, and there are many tempting opportunities to strike it rich. But be sure to advise your clients that the best approach is to balance opportunity with thoughtfulness as to the risks and tax implications that cryptocurrency may generate.
