Ever since bitcoin entered the financial stage in 2009, cryptocurrencies have rapidly emerged as a significant and potentially lucrative investment opportunity, with values reaching record highs in 2021 and continuing to climb. It likely does not come as a surprise, then, that the striking success of cryptocurrency has attracted the attention of more than just investors. According to a recent report released by the Treasury Department[1], increased monitoring and reporting of cryptocurrency transactions will likely play a part in the White House’s plan to reduce the growing margin of tax revenue which is not reported and remitted to the IRS. Plans are already underway to require transactions over $10,000 to be reported to the IRS by brokers as a means to crack down on tax evasion. Therefore, it is now more important than ever for taxpayers dealing in cryptocurrencies to understand the tax implications presented by these transactions.
Recognizing Revenue
According to IRS Notice 2014-21 which guides virtual currencies (a broader category encompassing cryptocurrency), virtual currency transactions follow the same general tax principles as other property transactions. This means they are subject to capital gains treatment, the same as stocks or bonds. When a taxpayer receives cryptocurrency in exchange for goods or services, they recognize the fair market value of the currency on the date it is received as ordinary income as if the same amount of cash was received instead. This value then becomes the taxpayer’s basis in the cryptocurrency, which will be used to determine the amount of capital gain or loss when it is eventually traded to someone else. If the taxpayer instead purchases the cryptocurrency, their basis is equal to the amount they paid. Understanding how revenue is recognized in these transactions is paramount to effectively minimizing tax liability and avoiding pitfalls.
Opportunity 1: Timing of the Sale
Capital gains and losses are separated into two categories based on the length they were held by the taxpayer: short-term gains/losses are generated when an asset has been held for less than one year, whereas long-term gains/losses occur when assets were held for one year or more. The clock starts running the day after the asset is acquired and ends on the day it is transferred to another party. The tax code treats short-term gains essentially the same as other income, subject to the same tax rate. However, long-term gains receive a beneficial rate which can be either 0%, 15%, or 20% under the current code, depending on the taxpayer’s income. An effective and simple strategy for minimizing taxes on cryptocurrency transactions is to hold them until they become long-term assets. The taxpayer can benefit even more if they are able to time the sales to land in years where income is lower, possibly even paying no tax at all.
Opportunity 2: Donating to Charity
Another tactic that can mitigate the tax consequences of selling cryptocurrency is to donate it to a qualified charity under Section 501(c)(3). The current provisions governing charitable contributions allow the taxpayer to take the fair market value of an appreciated asset as a deduction in arriving at taxable income, assuming they opt to itemize their deductions rather than take the standard deduction. Currently, these contributions can generate a deduction of up to 30% of the taxpayer’s adjusted gross income for the year and can be carried forward over the next 5 years.
Opportunity 3: Estate Planning
Like other capital assets, cryptocurrencies can be included as a part of an estate and are eligible to receive the same preferential basis treatment. When a taxpayer passes away, those assets attain a step up in basis, meaning any increase in the value of the assets since their purchase and until the date of death will not be taxable to those who inherit them. Alternatively, cryptocurrency can be gifted to others up to a certain amount without generating tax reporting requirements – this was $15,000 per person per year in 2021. While the recipients will have the same basis as the giver instead of the favorable stepped-up basis enjoyed by the inherited property, this is still a viable option for eliminating capital gain liability and may work out favorably if the recipient falls into a lower capital gains tax bracket.
Avoiding Common Tax Pitfalls
While there are many tax planning opportunities like the few listed here, it is critical that taxpayers take care to avoid unwanted consequences by planning transactions carefully. Many individuals dealing in cryptocurrency do not realize that simply using it to buy goods or services constitutes a sale, which in turn generates a gain or loss. Even more, doing so within the same year the currency was acquired may create a short-term gain, taxable at ordinary income rates. It is also important to consider that cryptocurrency transactions fall under the same substantiation requirements as other asset sales under the Internal Revenue Code. As such, taxpayers are required to keep documentation of any exchanges that take place to substantiate proceeds and basis calculations.
Conclusion
The items discussed here represent only a fraction of the numerous considerations surrounding cryptocurrency transactions. Information released by FinCEN (Financial Crimes Enforcement Network) indicates that they intend to revisit the reporting requirements concerning foreign investments and transactions of cryptocurrency. These have traditionally been exempt from annual reporting on Form 114, which is required for any taxpayer who has over $10,000 in a foreign account at any point during the year. Failure to comply can lead to steep penalties. Although it can be a profitable investment option, taxpayers should ensure they are cognizant of the risks and taking advantage of the opportunities to reduce any taxable impact where they arise.
[1] U.S Department of the Treasury, “The American Families Plan Tax Compliance Agenda”, May, 2021 (https://home.treasury.gov/system/files/136/The-American-Families-Plan-Tax-Compliance-Agenda.pdf)
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