Editor: Theodore J. Sarenski, CPA/PFS
Imagine that a client or a prospective client reaches out, seeking advice on the most tax-efficient way to divest virtual currency that has appreciated significantly since it was purchased some years ago. Knowing that virtual currency is treated as property for tax purposes, what strategies come to mind that would help the client achieve her objective? Following are six strategies that advisers might consider when working with clients who have appreciated virtual currency (aka cryptocurrency or cryptoassets).
Tax bracket management
This thought might come to mind first: Specifically identify high-basis units of the cryptoasset and sell them to take advantage of preferential tax rates on assets that are held for more than one year. The client could sell just enough cryptocurrency so that she does not trigger any capital gains taxes or get pushed into a higher tax bracket. For example, in 2020, if she is filing as a single individual, she could sell cryptoassets with enough inherent capital gains that, when added to any other income, and minus applicable deductions, her total taxable income does not exceed $40,000 ($80,000, if she is married and filing jointly), and she would pay no federal income tax on the capital gains. Like many of the other strategies covered in this column, depending on the dollar value of the cryptocurrency holdings, divesting the entire asset holdings might require multiyear planning.
If avoiding taxes entirely is of great importance to the client, she could establish residency in a more tax-friendly jurisdiction (e.g., the Bahamas) and renounce her U.S. citizenship. If renouncing her U.S. citizenship is a bit too extreme, she could at least establish residency in a U.S. state that has no income tax.
Borrowing or lending crypto
There is a rapidly growing ecosystem in the crypto space called decentralized finance, or DeFi, which is the market for lending and borrowing cryptoassets. Lenders will seek the highest yield possible on their cryptoassets (this is called yield farming). Interest earned while lending the cryptoasset will, of course, be taxed at ordinary income rates, so unless the asset is held in a tax-deferred account such as a self-directed individual retirement arrangement (IRA), this strategy might be suboptimal from a tax perspective.
Borrowing against a cryptoasset allows the client to diversify into a different type of cryptoasset (please note that cryptoassets tend to be highly correlated, so this would likely be diversifying within a similar asset class), as well as to deduct the interest expense, to the extent that there is investment income. The client could borrow dollars instead of cryptocurrency, but to qualify for an interest deduction, she would need to invest the dollars. It is also worth mentioning that crypto loans are typically overcollateralized, so if the client stakes $100 worth of a cryptoasset as collateral, the maximum loan value she could expect might be as little as $50. Lastly, cryptocurrency tends to be highly volatile compared to other asset classes such as stocks, so the client would need to anticipate the possibility of margin calls.
The client could gift the cryptocurrency to an older friend or relative, such as a parent or grandparent, in the hopes of getting a Sec. 1014 step-up in basis when the friend or relative dies. However, the gift cannot be conditional, and the individual receiving the gift would need to live past one year from the date the gift is received to achieve a basis increase. To avoid using up the client's lifetime gift exemption, annual gifting (including gift splitting) might be considered.
For 2020, an individual taxpayer can elect to take an itemized deduction for cash donations of up to 100% of adjusted gross income (AGI), except for donations to a private foundation or a donor-advised fund (DAF). However, noncash donations to qualified organizations are still subject to a 30%-of-AGI limit. Additionally, for 2020, an individual (or a married couple filing a joint return) can claim up to $300 of charitable contributions as an above-the-line deduction if the standard deduction is claimed. However, if the total combined itemized deductions exceed the standard deduction threshold, then the taxpayer would be better off itemizing his or her deductions.
For example, the client could donate cryptoassets valued at $100,000 with a zero cost basis and claim a $30,000 tax deduction on her 2020 individual tax return, assuming she has at least $100,000 of AGI. Note that the IRS requires a qualified appraisal to substantiate charitable deductions from all noncash property worth more than $5,000.
Qualified opportunity fund
A Sec. 1031 like-kind exchange cannot be made with virtual currency; however, selling the cryptoassets and investing the gains from the sales proceeds in a Sec. 1400Z-2(d) qualified opportunity fund (QOF) would allow the client to completely divest of cryptocurrency while also giving her access to her original cost basis in the cryptoassets, as well as the ability to defer the recognition of capital gains. In addition, if the client holds the QOF investment for five years, she is eligible for a 10% exclusion of the deferred capital gains on the QOF investment in the fund from gross income; and if the client holds the investment for seven years, she is eligible for a 15% exclusion of the deferred capital gains on the QOF investment from gross income. If she holds the investment for 10 years, she can exclude 100% of the QOF investment's appreciation from gross income. This tax treatment would be much more advantageous for the client than a Sec. 1031 like-kind exchange.
This type of tax and financial planning is where CPAs can shine as advisers and show their value to clients. Because the IRS deems virtual currency to be property, it has a few unique tax treatments, but it is not much different from any other asset from a tax perspective. Therefore, many of the strategies covered in this column could be applied to just about any low-cost-basis asset, not just cryptocurrency. <
|Ryan Firth, CPA/PFS, CCFC, is the founder and president of Mercer Street Co., an independent financial planning and investment advisory firm in Houston. John Strohmeyer, J.D., LL.M., is the founder and owner of Strohmeyer Law PLLC in Houston. Theodore J. Sarenski, CPA/PFS, is a wealth manager at Capital One/United Income in Syracuse, N.Y. Mr. Sarenski is chairman of the AICPA Advanced Personal Financial Planning Conference. He is also a past chairman of the AICPA Personal Financial Planning Executive Committee and a former member of the Tax Literacy Commission. For more information about this column, contact firstname.lastname@example.org.