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Cryptocurrency 101: What is Cryptocurrency Exactly?
Cryptocurrency is a digital currency that uses cryptography for security. Examples are Bitcoin (BTC) and Ether (ETH). Cryptocurrency (or crypto) is decentralized, meaning it is not controlled by a central authority such as a government or financial institution. A decentralized digital ledger based on blockchain technology records transactions across a network of computers, generating economic value for the participants securing the network. Use cases for specific blockchains or tokens vary, but many believe crypto is the future of finance.
Non-Fungible Tokens (NFTs)
NFTs are non-fungible compared to cryptocurrencies, which are fungible. NFTs often represent unique items on the blockchain, such as art, collectibles, and virtual real estate. NFTs surged in popularity in 2021, with some selling for millions of dollars. Use cases for NFTs are constantly evolving, and tax professionals need to stay current with the latest guidance and best practices
Decentralized Finance (DeFi)
DeFi refers to financial services built on blockchain technology and operating without intermediaries such as banks or credit card companies. DeFi aims to make transactions cheaper, faster, and more efficient by eliminating intermediaries from transactions.
DeFi has recently gained popularity due to the availability of various products and services including liquidity pools, yield farming and decentralized exchanges.
Liquidity Pools are collections of cryptocurrencies locked in a smart contract, allowing users to seamlessly trade on decentralized exchanges.
yield farming refers to the staking of tokens into liquidity pools in exchange for interest – or income – in the form of tokens.
The regulatory landscape for DeFi is still evolving, and tax professionals need to be aware of this when advising clients. There are more conservative and less conservative accounting approaches to DeFi, and tax professionals need to understand the tradeoffs and risks involved with each approach.
Basics of the crypto tax
IRS Virtual Currency Guidance
The IRS considered all digital assets to be tangible personal property, per IRS Notice 2014-21. Since cryptocurrencies like bitcoin are digital assets, they are also treated as property. Therefore, all general property tax rules also apply to cryptocurrencies.
Think of cryptocurrency similar to a stock unit. The amount you pay to get it forms the cost basis. If you sell it, there will be proceeds from the sale. The difference between these two is a win or loss.
Editor’s Note: Cryptocurrencies are not treated as currency for tax purposes. For more detailed information on this, see the top cryptocurrency-related terms in this recent article on the state of crypto and taxes in 2023.
In addition to Notice 2014-21, the IRS issued Rev. Rul. 2019-24 and 46 Virtual Currency FAQs in 2019.
The revenue rule addresses how to deal with hard forks (permanent redirection from an existing distributed ledger) and subsequent airdrops (distribution of a cryptocurrency to multiple recipients). The 46 virtual currency FAQs expanded on the original 16 FAQs in the 2014-21 notice.
When are crypto transactions taxed?
For federal tax purposes, common taxable cryptocurrency transactions include:
- Sale of cryptocurrency and/or NFT for cash (withdrawal)
- Trade a cryptocurrency and/or NFT against another cryptocurrency (or NFT).
- Issuing cryptocurrency for goods or services
- Earning cryptocurrency through staking, mining, rewards or wages
- Obtaining a new cryptocurrency as a result of a hard fork or an airdrop
Editor’s Note: For information on state-specific crypto taxes, including which states tax specific cryptocurrency transactions, see this recent article on Cryptocurrency and State Tax Legislation.
Capital Gains Tax vs. Ordinary Income Tax
Cryptocurrency disposal events – such as B. withdrawals, exchanging one cryptocurrency for another, or issuing cryptocurrencies for goods or services – are generally subject to state capital gains tax.
Cryptocurrency earnings (staking, mining, rewards, etc.) and earnings from hard forks and airdrops are subject to ordinary federal income taxes.
2022 form 1040 digital asset question
The IRS continues to refine and update the cryptocurrency question on Form 1040. In 2022, the IRS appears to be taking a more direct approach than it did in 2021, further defining the terms used in the question.
There are three notable changes in the 2022 question compared to the 2021 question.
- The IRS expanded the scope of the question and replaced the words “virtual currency” with “digital assets.”
digital assets is any digital representation of value recorded in a cryptographically secured distributed ledger or similar technology. The broader definition clearly includes non-fungible tokens (NFTs) and any asset with “the characteristics of a digital asset.” - The “Receive” category is further specified.
Receiving now includes receiving a bounty, award, or payment for property or services. - The somewhat ambiguous term “financial interest in digital assets” is clarified in the guide.
The IRS now defines a financial interest in a digital asset when someone is the registered owner of a digital asset or has an ownership interest in an account that holds one or more digital assets, including the rights and obligations to acquire a financial interest, or owns a wallet containing digital assets.”
Taxpayers can safely tick “no” to the cryptocurrency question in three situations when it comes to digital assets:
- In 2022, digital assets held in a wallet or exchange.
- Bought in 2022 with USD or fiat currency.
- Transferred between wallets/exchange accounts owned by the taxpayer in 2022.
Compliance challenges for tax professionals
There are several challenges that tax professionals face when reporting cryptocurrency transactions.
Missing 1099-B reporting
With the exception of a few brokers like Robinhood, CashApp, Etoro & PayPal, the vast majority of US cryptocurrency exchanges do not issue 1099-Bs to taxpayers. Additionally, foreign cryptocurrency exchanges and decentralized exchanges have almost no annual profit and loss reporting. This shifts the burden of keeping records and calculating annual profits and losses to tax professionals.
The Infrastructure Act required cryptocurrency exchanges to report revenue and cost baseline information to the IRS beginning in the 2023 tax year. However, the recent IRS Announcement 2023-2 delayed the effective date of this reporting requirement. It is likely that the rule will come into effect for the 2024 tax year.
Multiple wallets & cost-based tracking
When a taxpayer has multiple wallets and exchange accounts with transfers between them (which is very common in crypto, according to a survey conducted by CoinTracker), it is extremely difficult to manage the disposal settlement method (FIFO, LIFO, or specific ID) and track the Cost basis of each token and each transaction.
The above compliance challenges can be overcome by using CoinTracker. CoinTracker is a data aggregation tool that connects to your clients’ cryptocurrency exchanges and wallets and generates reconciled profit/loss reports for tax purposes. Without a tool like CoinTracker, it is virtually impossible to reconcile virtual currency transactions and generate accurate profit/loss reports.
Tax professionals need to be aware of the growing importance of cryptocurrency in the financial world. This includes understanding the basics of cryptocurrency, becoming familiar with new developments such as NFTs and DeFi, and keeping up to date with tax regulations and guidance.
Disclaimer: This post is for informational purposes only and is not intended as tax advice. For tax advice, please contact a tax advisor
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