The Focus - Our Tax E-Newsletter
Wrangling the Cryptocurrency Wild West
Many people wonder what cryptocurrency is. Cryptocurrency is a digital form of money maintained through a computer network that is not reliant on a centralized system, like the government or a bank. Theoretically, the decentralized structure makes them immune to governmental manipulation. This type of currency exists only online, and encryption is used to authenticate and preserve transactions. 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." It is a type of currency other than "real" traditional currencies, like the US dollar, the European euro, or an Indian rupee.
Convertible virtual currency is virtual currency that has an "equivalent value in real currency or acts as a substitute for real currency." Bitcoin is largely recognized as being the first convertible virtual currency after being introduced in 2009. It remains the most traded cryptocurrency, even as many other cryptocurrencies have been launched. As of late 2021 Bitcoin represented about 41% of the value of all cryptocurrencies. The cryptoasset market value is approximately $2.75 trillion, and will most likely grow as more crypto assets gain popularity. In May 2010, Bitcoin was first commercially traded for two Papa John's pizzas. In February 2022, cryptocurrency was used to purchase a billion year old black diamond for $4.3 million. Clearly, the transactions of cryptoassets have changed widely over the years, which could explain why the IRS has been slow to offer guidance on this unique form of exchange.
Over the past few years the IRS has become increasingly interested in cryptocurrency transactions, evidenced by the IRS now asking about it on page 1 of the Form 1040. Traditionally, taxpayers buy or sell assets through an investment company (like Merrill Lynch or Wells Fargo). This makes it easy to report transactions on a tax return, as the company sends the appropriate 1099 form to you with the applicable information to include. The problem with cryptoassets is that they can be very difficult to track. The buying and selling does not necessarily happen all in one place, and there are no companies yet issuing Form 1099's reporting transactions. It is up to each person to record and keep track of what his or her gains and losses are. This also means it is easy for taxpayers to incorrectly report transactions if they are not keeping up to date records all year long. In addition to this, some people are under the impression that because these transactions happen anonymously online (especially when paid in cryptocurrency), the IRS has no idea what a person has done, and end up not reporting anything. However, the IRS has various ways of uncovering taxable cryptoasset transactions.
On the 2019 individual tax return (Form 1040, Schedule 1), taxpayers were first asked about virtual currency: "did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency." Recently, the IRS offered further guidance, deciding that taxpayers can mark the question "no" if they only purchased a crypto asset. This is illustrated by the reworded specific question on the front page of the 2021 return: "At any time during 2021, did you receive, sell, exchange or dispose of any financial interest in virtual currency." The placement of this question from Schedule 1 in 2019, which not all taxpayers use or look at, to the front page of the return in 2020 conveys the IRS's rising interest in cryptoassets and the answer that taxpayers give. This question is used to help the IRS see if there is an issue of underreporting, as some people did not realize that participating in cryptocurrency transactions could be a taxable event, or that the IRS would even be interested in it. There have been concerns that there is a "tax gap;" that cryptocurrency is a tax evasion risk with a need for stricter rules in order to force compliance on the cryptoasset market and transactions. By answering the question on your tax return, you are definitively stating your level of involvement with cryptoassets. Not answering truthfully could lead to legal issues with the IRS. As cryptoassets become more popular and accessible, the IRS is interested in capturing the tax revenue created by the use of cryptoassets. So, this question is being used to gage the financial practices of taxpayers, how best to structure future tax laws, and reporting requirements.
The IRS has started issuing some guidance regarding cryptoassets. Just like other types of assets, when virtual currency is exchanged the IRS will tax the transaction accordingly. In 2014 with IRS Notice 2014-21, the IRS defined virtual currency as property in tax situations. This means that when you sell, trade or spend cryptocurrency (essentially all deemed to be a "sale" of cryptocurrency), you need to report this on your tax return (Form 1040, Schedule D) as you are subject to capital gains tax (like a stock sale). The difference between the purchase price and the "sale" price will result in either a capital gain or loss. If you sold cryptocurrency for more than you bought it for and held it for more than one year, that gain will be taxed at capital gain rates. If taxpayers experience losses they are able to deduct up to $3,000 of capital losses each year, and any remaining losses can be used in future years. This may allow for taxpayers to manage the gains they recognize each year as cryptoassets are known for being unpredictable; the cost could fluctuate in either direction, meaning you may be able to control the amount of capital gain tax you pay by selling cryptoassets in order to create losses.
Under IRC Code Sec. 1091(d) cryptoassets are considered property, so they are not subject to the wash sale rules. A wash sale is when you dispose of an asset at a loss and then rebuy the same or similar asset within a 30 day window. Losses from wash sales are not deductible. The creation of the wash sale rule was to prevent "fake" losses; purposely selling assets at a loss in order to offset gains, only to later repurchase them. Some have taken advantage of the volatile cryptoasset market in order to sell assets at a loss to decrease their other tax on gains, and then buy the asset again.
As the cryptoasset market continues to evolve and gain in popularity, it will be important for taxpayers to keep up to date with law changes. The IRS sees the cryptoasset market as a way to increase tax revenue, and will continue to tax cryptoasset transactions, and issue more regulations. There are many issues with cryptoassets that require further guidance. Please reach out to your DB&B tax advisor for questions and further assistance.
The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.