Editor: Todd Miller, CPA
Over the past several years, the world has seen the rise, fall, and multiple evolutions of cryptocurrencies and other cryptoassets. In 2021, the price of a bitcoin briefly topped $64,000, a collection of Beeple's artwork sold for $69 million as a nonfungible token (NFT), trading cards became virtual through sites like NBA Top Shot, and one of the largest virtual currency exchange platforms became a public company.
Regardless of an adviser's valuation or opinion of these blockchain technology-based assets and their potential for future skyrocketing appreciation or bubble-bursting decline, it is clear that cryptoassets are here to stay, and tax advisers need to be ready as more and more clients begin to engage in transactions involving these types of assets.
Coming into the filing season for 2021 returns, here are four things for financial and tax advisers to keep in mind when working with clients holding cryptoassets.
How the IRS views and treats virtual currency
The first important thing to be aware of is the IRS's general understanding of these assets. In Notice 2014-21, the Service defines "virtual currency" as "a digital representation of value," other than a representation of the U.S. dollar or a foreign currency ("real" currency), that "functions as a medium of exchange, a unit of account, and/or a store of value." Some virtual currencies are "convertible," which means that they have an equivalent value in real currency or act as a substitute for real currency.
In the IRS's view, then, virtual currency is not recognized as traditional currency like the dollar or euro. When an individual exchanges a piece of virtual currency, he or she is exchanging a unit of property and is taxed accordingly. More recently, the IRS has been moving to refer to all forms of virtual currency and other virtual assets simply as digital assets.
As these assets are classified as property, they are not subject to wash-sale rules under Sec. 1091(d). This may allow for taxpayers to manage recognized gains in a given year, as some of these assets may be quite volatile in either direction throughout the course of a year.
It should be noted that Congress does have its eye on this aspect ofcrypto-assets, and the Build Back Better Act, being debated at the time of this writing, contains a provision that would specifically subject cryptoassets to the Sec. 1091(d) wash-sale rules. If the provision is enacted, this potentially could create a substantial administrative challenge to taxpayers in managing transactions across multiple accounts or wallets.
Disclosure on Form 1040 requirements
The second thing for advisers to keep in mind about cryptoassets is, beginning with the 2019 individual tax return, the IRS has been asking taxpayers to affirmatively mark "yes" or "no" as to whether they acquired or disposed of a position in a virtual currency. For 2019, this question was at the top of Schedule 1, Additional Income and Adjustments to Income, but for 2020 and forward, the question was moved directly to the front of Form 1040, U.S. Individual Income Tax Return. As drafted for the 2021 Form 1040, the question reads: "At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?" This is a question that all taxpayers must address in filing their return. In March 2021, the IRS did update its FAQs to clarify that "receive" does not mean a purchase of virtual currency with real currency. So, if a taxpayer's only action in a given year was to purchase a cryptoasset, then this question may be marked "no."
This question on Form 1040 is intended to help the IRS address an area where it believes there is underreporting. Through litigation over the last several years, the Service has gained access to some information from virtual currency exchanges about individuals and their transactions. With this type of information, the IRS was able to issue Letters 6173, 6174, and 6174-A to address potentially underreporting taxpayers.
Future FBAR implications
Something else to be aware of is the possibility of future FBAR reporting requirements. In late 2020, Treasury's Financial Crimes Enforcement Network (FinCEN) issued Notice 2020-2 stating that its current "regulations do not define a foreign account holding virtual currency as a type of reportable account." For that reason, the notice explains, a foreign account holding virtual currency is not reportable at this time on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), unless it is a reportable account under 31 C.F.R. Section 1010.350 because it holds reportable assets besides virtual currency. FinCEN goes on to say that it is looking to amend its definitions in the future so that virtual currencies are included as a reportable currency.
Tax advisers should keep their eyes open for future reporting requirements, as the penalties associated with failing to report accounts begin at $10,000 per unreported account. For many taxpayers, an FBAR penalty would come as a surprise, as the physical location of their positions is not something on the front of their minds; additionally, as it is so easy to open or close accounts or transfer funds, the potential for having multiple accounts is high (as is the related potential for high penalties).
Keep an eye on the character of the income
Finally, in helping clients with digital assets, it is important to keep in mind that the character of the income and the economic background of the transaction will affect its taxation. Most clients will be traders of cryptoassets — similar to what would be seen with traditional stocks, bonds, and mutual funds. For these types of investors, income and loss will be treated as capital gains and be subject to ordinary and capital gains rates accordingly. Additionally, this will mean that gains may also be subject to the 3.8% net investment income tax. For NFTs, these may actually be taxed as collectibles at a 28% rate, as NFTs are often used on works of digital art under Sec. 408(m). No specific guidance on this topic has been outlined by the IRS as of this writing.
In situations such as a hard fork or an air drop, taxpayers may receive cryptoassets without any purchase price. Once the cryptoasset is placed on the ledger and the taxpayer has control over it, this becomes a recognition-of-income event. This income will be classified as ordinary income and will become the cost basis of the asset for when it is subsequently disposed of.
On top of all this, there may be clients who are active in maintaining various blockchain protocols or communities by performing complex mathematical equations to show proof of work or proof of stake. In return for their efforts, they may receive distributions, tips, rewards, or payments of various cryptoassets. This payment will be ordinary income upon receipt and be taxable when received. Depending on the regularity and the effort undertaken by the taxpayer, these activities may rise to the level of an active trade or business and cause the earnings to potentially be subject to self-employment taxes as well.
As this is a new and ever-expanding medium of business and assets, for every answered question, another two arise. Additionally, various national and international governments are looking to enact further regulations to manage and capitalize on these assets. As additional guidance is anticipated, it is advisable to be working with clients to have quality data and tracking of these activities to easily adjust to future regulations. Due to the nature of these transactions and the various accounts in which taxpayers may hold cryptoassets, it may become a tedious task to track and report the potentially thousands (if not hundreds of thousands) of lines of transactions. Many first-party and third-party tools in the market can aggregate transactions and help clients manage their positions and report the tax implications.
Todd Miller, CPA, is a tax partner at Maxwell Locke & Ritter in Austin, Texas.
For additional information about these items, contact Todd Miller at 352-727-4155 or email@example.com.
Contributors are members of or associated with CPAmerica Inc.