Editor: Carolyn Quill, CPA, J.D., LL.M.
Co-editors: Richard Mather, E.A., MSA, CAA; Jonathan McGuire, CPA; and Kathleen Moran, CPA, MBA, MT
According to Crypto.com, the global population of cryptoasset owners has been increasing greatly, jumping 178% from 106 million in January 2021 to 295 million in December 2021. Using cryptoassets (aka digital assets) for transactions has become much easier because payment processors such as PayPal and various digital payment and fundraising platforms recognize it, and companies such as Visa and Mastercard have started issuing crypto debit and credit cards. The versatile uses of these digital assets are now expanding to charitable giving. This item discusses key tax considerations for donors and charitable organizations that wish to give or receive digital asset donations.
Cryptoassets, which the IRS generally calls virtual currency, are treated as property under the current IRS guidance, Notice 2014-21. The IRS defines virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. The Service goes on to explain that the notice applies only to “convertible” virtual currency, which is virtual currency that has an equivalent value in real currency or that acts as a substitute for real currency. The IRS has not issued specific guidance on other types of cryptoassets, such as nonfungible tokens (NFTs). However, given the IRS position and reasoning that convertible virtual currency is not treated as “currency,” both nonconvertible virtual currency and NFTs are likely property for federal tax purposes.
Potential deductibility limitations when donating cryptoassets
The focus of the present discussion is on charitable giving of cryptoassets. When property is donated, the donee charity recognizes noncash receipts, and the donor may claim a deduction if the donation is made to a qualifying charity under Sec. 170(c). The donor’s charitable contribution deduction is subject to certain limitation rules under Sec. 170, depending on the character of the contributed property and the donee charity’s use of the donated property, among other things.
Character of donated cryptoassets: The character of the donated property can be either ordinary income property or capital gain property, and this may affect the amount of the charitable deduction. Property is ordinary income property if ordinary income or short-term capital gain would have been recognized had the property been sold at fair market value (FMV) on the date it was contributed. Property such as inventory, works of art created by the donor, manuscripts prepared by the donor, or capital assets held one year or less would be ordinary income property. Conversely, property is capital gain property if long-term capital gain would have been recognized had it been sold at FMV on the date of the contribution. Capital assets held more than one year would be capital gain property.
“Capital asset” is defined by what is not a capital asset. Under Sec. 1221, a capital asset is any “property held by the taxpayer (whether or not connected with his trade or business).” Thus, the default classification for cryptoassets would be capital asset, unless they are one of the non–capital assets listed in Sec. 1221(a). It is possible that cryptoassets could fall into the non–capital asset criteria under Sec. 1221(a) and be characterized as ordinary income property. For example, when the donor holds cryptoassets primarily for sale to customers in the ordinary course of her trade or business, those cryptoassets would be inventory under Sec. 1221(a)(1). If an artist who carries out his art activity as a business creates an NFT representing a piece of art, that NFT would be inventory rather than a capital asset.
Although the deductible amount of charitable contribution to a qualified organization is generally the FMV of the property at the time of the contribution, the character of donated property can limit the deductible amount. The deductible contribution of ordinary income property is limited to the lesser of the FMV at the time of donation or the donor’s basis. The rule is different for a donation of long-term capital gain property. If the donated cryptoasset is capital gain property held more than one year at the time of the donation, the charitable contribution deduction is based on the cryptoasset’s FMV. If the donor held the cryptoasset for one year or less at the time of the donation, or the cryptoasset was inventory in the hands of the donor, the deduction is the lesser of the basis in the cryptoasset or its FMV at the time of the contribution.
Charity’s use of donated cryptoassets: In addition to the character of donated property, the donee charity’s planned use of the donated property also affects the deductible contribution amount. If donated property is tangible personal property and the donee’s use is not related to its tax-exempt purpose (“unrelated use”), the charitable deduction is limited to the basis in the donated item under the reduction rule in Sec. 170(e)(1)(A). For example, if an artist contributes a painting to an art school and the art school uses the painting for educational purposes by placing it in its library for display and study by art students, the use is not considered to be unrelated; but if the art school sells the painting and uses the proceeds for educational purposes, the use of the donated painting is considered unrelated.
This unrelated-use test applicable to donations of tangible personal property might apply to certain types of NFTs. NFTs are digital certificates that serve as receipts of ownership for not only digital properties such as digital art, videos, and files but also, increasingly, for tangible personal property. In the NFT market, there are now NFTs linked to the ownership of physical objects such as vehicles or yachts. Hypothetically, if an NFT represents the right to the full ownership of a yacht when certain conditions are met, would that NFT essentially be considered the yacht once the conditions are satisfied? If so, a person donating the NFT to a charity may need to worry about the unrelated-use test.
Potential difficulties in determining fair market value
In calculating the amount of the charitable deduction, FMV determination is critical. However, figuring out the FMV of cryptoassets can be difficult, depending on the circumstances. Many cryptoassets can only be traded with base cryptoassets such as bitcoin or ethereum, requiring basis tracking across multiple transactions. Similarly, the majority of NFTs can only be purchased with cryptoassets rather than with fiat currency (government-issued money, such as a U.S. dollar, euro, or yen). Therefore, determining FMV and basis tracking can be challenging for both donors and donees, particularly when multiple crypto transactions are involved in the original acquisition.
Another potential difficulty is that, for tax purposes, transactions involving virtual currency must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the FMV of virtual currency in U.S. dollars as of the date of payment or receipt. While this may not be a problem for a cryptoasset that is listed on an exchange because the FMV could be determined by the exchange rate established or posted on that exchange, for brand new cryptoassets or newly minted NFTs, there may not be established markets or exchange rates quoted. Moreover, there may sometimes be numerous exchanges providing different valuations for the same cryptoasset at any given time. It could be difficult or time-consuming for taxpayers to track basis without an additional basis-tracking tool (e.g., commercial software or applications for basis tracking).
The current IRS guidance allows the specific identification and first-in-first-out valuation methods but is silent on the average-cost method and other alternative valuation methods such as the last-in-first-out or highest-in-first-out methods. In circumstances where taxpayers hold multiple cryptoassets or pools of cryptoassets in multiple wallets or exchanges, it could be especially daunting to track basis by specifically identifying each unit of the cryptoasset.
Recordkeeping and reporting requirements for donors
Another set of issues involves recordkeeping and reporting requirements. Individual taxpayers report and claim a tax deduction for charitable donations on Schedule A, Itemized Deductions, filed as part of the taxpayer’s Form 1040, U.S. Individual Income Tax Return. Because cryptoassets and NFTs are property rather than currency, donated cryptoassets and NFTs should be reported as noncash donations. To properly claim a deduction for a charitable donation of noncash property, including digital assets, a taxpayer must adhere to a number of substantiation and reporting requirements.
For donations valued at less than $250, the donor must keep a contemporaneous receipt from the charitable organization documenting the charity’s name and address. To properly claim a tax deduction for a contribution over $250, the donor must obtain a contemporaneous written acknowledgment from the charitable organization prior to the earlier of (1) the date the donor’s tax return is filed, or (2) the due date of the return (including filing extensions). To claim a tax deduction for donated property valued at over $500, donors must also complete and include with their tax return Form 8283, Noncash Charitable Contributions.
Qualified appraisal: If the donor claims a contribution deduction greater than $5,000, Sec. 170(f)(11) requires a qualified appraisal of the donated property to be obtained and attached to the donor’s tax return. There are several specific requirements for a “qualified appraisal” and a “qualified appraiser” under the Treasury regulations (see Regs. Sec. 1.170A-17(a)(2)). These include the requirement that the appraisal be prepared by a qualified appraiser in accordance with generally accepted appraisal standards that meet the substance and principles of the Uniform Standards of Professional Appraisal Practice. The qualified appraisal must be signed by both the qualified appraiser and the recipient charitable organization. The recipient organization’s signature on a qualified appraisal represents acknowledgment of receipt of the donated asset on the specified date and that the organization understands the information-reporting requirements imposed on dispositions of the donated property. The signature does not represent the organization’s agreement with the appraised value of the property.
Publicly traded stocks are generally exempt from these qualified appraisal requirements. The current IRS guidance does not specifically provide a similar exception for cryptoassets, even though values of many cryptoassets are readily available on public exchanges, and crypto transactions are usually transparent and open on a blockchain. For NFTs, specific appraisal requirements set out in the current regulations would likely be difficult to meet.
Reporting requirements for recipient charities
The charitable organization receiving a donation of cryptoassets has reporting requirements, too. Recipient organizations report noncash contributions on line 1g of Part VIII, Statement of Revenue, and line 14 of Part X, Balance Sheet, filed as part of the organization’s Form 990, Return of Organization Exempt From Income Tax. A recipient organization must also complete and include with its tax return Schedule M, Noncash Contributions, which breaks out the various types of donated property received and reports the number of Forms 8283 received by the organization during the tax year for which the organization completed Part V, Donee Acknowledgment. If a recipient organization sells the donated property within three years of receipt, the organization must file Form 8282, Donee Information Return, upon the disposition of the donated assets and provide a copy of the completed form to the original donor.
Given the increasing popularity and prevalence of cryptoassets, it is imperative for taxpayers and tax professionals alike to stay current on the tax regulations that govern cryptoasset transactions and donations. For charitable organizations, cryptoassets can provide significant new sources of funding. For donors, cryptoasset donations can provide substantial tax savings through optimizing deductions. Careful consideration is needed, however, of the tax ramifications of donating this newest class of assets.
Carolyn Quill, CPA, J.D., LL.M., is the lead tax principal at Thompson Greenspon in Fairfax, Va. Richard Mather, E.A., MSA, CAA, is a director at EFPR Group in Rochester, N.Y.; Jonathan McGuire, CPA, is senior tax manager at Aldrich Group in Salem, Ore.; and Kathleen Moran, CPA, MBA, MT, is a director at Pease Bell CPAs in Cleveland. Unless otherwise noted, contributors are members of or associated with CPAmerica Inc. For additional information about these items, contact Carolyn Quill at email@example.com.