Its recent swoon aside, cryptocurrency continues to make incursions into the mainstream, with roughly 200 million people worldwide using or having used it, large companies like Skybridge Capital and Tesla owning it on their balance sheets and professional athletes signing contracts to be paid in digital currencies. There are now more than 18,000 cryptocurrencies in existence, with a market capitalization of more than $2 trillion.
For financial professionals, the growing interest from clients calls for greater understanding of the new asset class and its tax liabilities. Crypto taxes are still something that many people and organizations don’t quite grasp, as investors are left to calculate and report their losses to the IRS in the wake of stable coin Terra’s collapse and impact on the broader market.
With that in mind, here are key considerations to keep in mind about the way crypto is currently taxed, and how the landscape is changing and is expected to evolve.
Property or currency?
How cryptocurrencies are taxed largely depends on how crypto came into the client’s possession. The answer to this question can and likely will determine how their tax liability is defined: Are you purchasing or investing in cryptocurrencies through an exchange, mining cryptocurrency or are you getting paid in cryptocurrency?
For those purchasing and investing in cryptocurrencies through an exchange, the most important thing to know is that the federal government views such crypto as property, not as currency. Since the IRS released a notice in 2014, its first on digital currencies, crypto has been taxed like property — which means taxable events occur when the crypto is sold or exchanged. The resulting gain is then subject to capital gains taxes, like stocks. Therefore, it is critical for crypto holders to establish a tax basis and track gains and losses. Once they sell or exchange holdings, they will be subject to capital gains taxes.
By contrast, for those who have “mined” a cryptocurrency such as bitcoin, or have been paid or compensated in cryptocurrency, the IRS will view it as income. For miners, crypto will be treated as income at fair market value on the date that it was mined. For those paid in crypto, crypto is considered ordinary income, like wages, and taxable at ordinary rates.
Any recipient of crypto within these circumstances will need to report their new crypto holding as gross income at a corresponding U.S. dollar value, along with any applicable business expense deductions, such as those for mining equipment.
Recent crypto taxation laws
The crypto tax framework has remained largely unchanged since its introduction in 2014. But in the past few years, as the U.S. government has become more familiar with the various ins and outs of the sector, it has taken action to address some key areas.
The Tax Cuts and Jobs Act, signed into law in 2017 by President Donald Trump, was the first piece of legislation to usher in a few changes. This law essentially eliminated the use of “like-kind” exchanges for all property other than real estate. In other words, if you exchange one cryptocurrency for another — for example, if you trade bitcoin for ethereum — this amounts to a taxable event. So, exchanging one virtual currency for another does not qualify for non-taxable, like-kind exchange treatment. A good rule of thumb: Any cryptocurrency trade is considered a taxable transaction.
In 2019, the IRS released further guidance relating to “hard forks” and “airdrops.” Simply put, hard forks are instances where a crypto’s blockchain network experiences a change or upgrade, often resulting in the formation of a new crypto token, typically received via airdrop, which is when free tokens are distributed to investors. The IRS’ revised guidance in 2019 addressed these instances by ruling that hard forks followed by an airdrop count as a taxable event.
Further changes are on the way. The Infrastructure Investment and Jobs Act, signed last November by President Joe Biden, requires that crypto brokers and exchanges issue investors 1099-B forms starting the 2023 tax year. New provisions in that law also require that any person or institution that receives more than $10,000 in crypto transactions report it to the IRS.
On an international level, the Organization for Economic Cooperation and Development (OECD) released a proposed global tax transparency framework for crypto in March If implemented, this framework would improve the existing Common Reporting Standard (CRS) shared between countries involving financial transactions to include cryptocurrencies.
These standards, which were originally implemented to combat tax evasion, require financial institutions to identify and share information regarding non-resident bank account holders with local tax authorities. That said, as the U.S. is not a part of the CRS network, it remains to be seen whether updated CRS rules would affect U.S.-based investors or businesses.
Record, report, self-regulate
What are the key takeaways for advisors, investors and other crypto-curious parties to keep in mind about taxation given the current framework and the upcoming changes?
As of right now, taxable events related to cryptocurrencies are only triggered when crypto is bought, sold, mined or otherwise transacted. For businesses and retail investors especially, this means it is critical to maintain clear records and keep track of cost basis and trades to accurately account for losses and gains. Failing to report trading activity, including losses or gains, could subject you to penalties. As exchanges will soon be issuing 1099-B documents, the IRS will also know exactly how much is owed.
That said, it is also important to note that there may be major changes to the crypto tax framework on the horizon. The Responsible Financial Innovation Act proposed by Sens. Cynthia Lummis and Kirsten Gillibrand in June would create a much clearer standard for defining when crypto is a security versus a commodity. While the goal is to create more clarity for regulators and protect consumers, it would ultimately complicate the tax picture for crypto as securities and commodities are already subject to a variety of tax considerations, including capital gains or losses, the level of trading activity on the part of the crypto holder and marking the asset to market at the end of the tax year regardless of whether it was sold. If the act becomes law, financial professionals will need to closely consult with tax experts to ensure that they fully understand how any crypto assets in their client’s portfolio may affect their overall tax burden.
Until major changes to the current crypto tax framework are implemented it is still essential for crypto holders to gain a solid understanding of how their holdings are currently taxed and to stay up to date on any additional developments in this rapidly evolving industry.