Cryptocurrency (crypto), is it a unit of account? A store of value? A medium of exchange? The answer is all of the above. Crypto is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. As cryptocurrencies become more mainstream, they have been redefining and expanding the world of finance with little guidance from the IRS since 2014.
That is about to change in the upcoming year as Congress passes the Infrastructure Investment and Jobs Act (IIJA). Congress anticipates paying for the IIJA through many different programs, including “strengthening tax enforcement when it comes to crypto currencies,” which we will detail further below. However you view your crypto currency, Congress and the IRS are telling the crypto community to get their affairs in order and be ready to report these transactions properly.
Crypto is treated as property for federal tax purposes, i.e., upon acquisition a basis in your crypto must be established through the fair market value (FMV) of the crypto as of the date of payment or receipt. Generally, gain or loss upon sale or exchange of your crypto would be calculated like securities, which receive capital gains treatment on amounts above or below your basis as of the date of sale or exchange (see below when operating as a trade or business). One advantageous caveat to crypto is that it does not currently adhere to wash sale rules (the IIJA intends to reverse course on crypto and wash sales, which is discussed further below). Below is a list of common acquisitions of crypto with rules on establishing basis and taxable gain or loss:
1. Purchasing crypto facilitated by an exchange – The basis is the amount recorded by the exchange for that transaction or the amount the crypto was trading for at the date and time the transaction would have been recorded. The gain or loss will be the difference between the basis established above and the sale price. The holding period will determine whether short-term or long-term capital gain will be realized.
2. Peer-to-peer transaction not facilitated by an exchange – The basis is determined as of the date and time the transaction is recorded on the distributed ledger or would have been recorded on the ledger if off-chain. The gain or loss will be the difference between the basis established above and the sale price. The holding period will determine whether short-term or long-term capital gain will be realized.
3. As payment for goods or services – The basis that a taxpayer establishes when receiving crypto as payment for goods or services is the FMV of the crypto as of the date of receipt. If the crypto does not have a published value, then the basis will be equal to the FMV of the goods or services exchanged when the transaction occurs. If the crypto payment is received for services carried on by an individual from any trade or business, then the payment is considered self-employment income and will be subject to self-employment tax.
The character of the gain or loss in this example is more detailed. Generally, it depends on whether the crypto is a capital asset in the hands of the taxpayer. A taxpayer realizes capital gain or loss on the sale or exchange of crypto that is a capital asset in the hands of the taxpayer. A taxpayer realizes ordinary gain or loss on the sale or exchange of crypto that is not a capital asset in the hands of the taxpayer.
4. As wages for employment – The basis in wages earned and paid in crypto is the fair market value of the crypto paid. The fair market value of the crypto paid as wages is also subject to federal income tax withholding, social security, Medicare and federal unemployment tax and must be reported on Form W-2.
5. Mining, staking, hard forks or air drops – When a taxpayer mines or stakes or receives crypto from hard forks or air drops the basis is the FMV of the crypto currency earned by/from mining, staking, hard forks and/or air drops as of the date of receipt. You must have dominion or control over the crypto for it to be considered in gross income, i.e., the ability to transfer, sell, exchange, or otherwise dispose of the crypto. This FMV is then reported as ordinary income on the taxpayer’s tax return. As stated in #3 above, if the mining constitutes a trade or business, then it is subject to self-employment tax.
6. Crypto received as a gift – Your basis in crypto received as a gift differs depending on whether you will have a gain or a loss when you sell or dispose of it. For purposes of determining whether you have a gain, your basis is equal to the donor’s basis, plus any gift tax the donor paid on the gift. For purposes of determining whether you have a loss, your basis is equal to the lesser of the donor’s basis or the fair market value of the virtual currency at the time you received the gift. If you do not have any documentation to substantiate the donor’s basis, then your basis is zero.
Your holding period for short-term or long-term treatment in the crypto received as a gift includes the time that the crypto was held by the person from whom you received the gift. However, if you do not have documentation substantiating that person’s holding period, then your holding period begins the day after you receive the gift. The gift is taxable to the gift giver, not the recipient.
As discussed above, the IIJA significantly increases the crypto reporting requirements. The IIJA broadens the term broker to “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person”. Digital assets also received a broadened definition as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the IRS.”
The IIJA includes digital assets in the definition of covered securities. This is significant because covered securities are required to be reported to the IRS by brokers with adjusted basis and gain included as well as reported under broker-to-broker transfers. Additionally, the IIJA adds digital assets to the current rules requiring cash payments to be reported over $10,000. Not included in the IIJA, but very significant to crypto investors now that digital assets are defined with covered securities, is the House Ways and Means Committee’s proposal amending wash sale rules to include digital assets.
The IRS is now responsible for generating the tax revenue promised by the IIJA. The days of just checking the box on your tax return for crypto purchases, sales, trades or exchanges is over. Keeping good records for your crypto transactions is now mandatory and beneficial. If you have records to back it up, the IRS will allow you to distinguish which assets you’ve sold when providing your basis. Otherwise, they will be liquidated in chronological order, which could trigger some significant gains on early investors.
SKP Accountants & Advisors is here to help with all your crypto questions. Contact us or call 203-933-1679.