Clarifying the Rules – IRS Guidance on Crypto Transactions (Part One)
The Internal Revenue Service continues to publish guidance on how the public should treat crypto transactions on their yearly tax returns. The most recent guidance along with FAQs can be found here.
This post will dissect the major guidance topics and discuss some ongoing issues. This area of tax law is still very much in its infancy. All taxpayers should work with their CPAs to ensure they are following the rules in place for the taxable year. This blog post is merely an informative look at the current state of the law and is not meant to provide advice for tax filings. For more information on various criminal tax issues, visit our pages devoted to criminal tax, tax fraud, and tax evasion.
What is Cryptocurrency in the Eyes of the IRS?
The IRS currently views cryptocurrency as property under the tax code. General property rules are covered in IRS publication 544 – “Sales and Other Dispositions of Assets.” The publication covers capital gains, basis, and specific issues with various forms of property (although they fail to address crypto assets specifically).
A taxpayer or CPA must apply the general property rules to crypto transactions to comply with the federal government’s guidance. A taxable transaction will occur when the taxpayer disposes of a cryptocurrency. Two key areas of disposition apply to the crypto market: 1) sale of property and 2) the exchange of property. The sale of property is a simple concept. If a person sells a piece of property, or crypto asset, a disposition has occurred under the IRC.
The exchange of property is still an emerging principle in crypto taxation. Under publication 544, a person may exchange real property for real property without triggering a disposition or taxable event. If the property is similar (“like kind”) then a disposition has not occurred under the IRC. The taxable event has been deferred until the new property is ultimately sold for a not like kind instrument such as cash.
In the crypto market, there are numerous trades conducted without the presence of the United States Dollar (“USD”). Many of the smaller project tokens are bought with Bitcoin or Ethereum. Under those facts, a taxpayer is not selling a cryptocurrency, but rather, exchanging Bitcoin for a smaller token. Prior to 2018, there was debate on whether exchanging crypto assets was a taxable event. However, the Tax Cuts and Jobs Act of 2017 specifically limited the like kind exchange principles of 26 U.S.C. § 1031 to real property transactions. Going forward, exchanging crypto assets will trigger a disposition event.
The result of this stance is that a taxpayer disposes of cryptocurrency each time they swap one token/coin for another. For example, let’s assume a taxpayer buys $2,000 in Bitcoin on August 1, 2020. On August 2, the taxpayer exchanges their Bitcoin for a smaller project like Icon (ICX). On August 3, 2020, the taxpayer exchanges Icon (ICX) for Balanced Tokens. The taxpayer has now disposed of various crypto assets in 3 days. Dispositions have occurred when the taxpayer exchanged Bitcoin for Icon and when Icon was exchanged for Balanced. Likely, the taxation will be negligible as those assets did not gain or lose much value in one day, but the implications are still daunting. Under a conservative approach, the taxpayer will need to track the gains and losses for both transactions on their yearly tax return. For a taxpayer that frequently purchases crypto assets, this requirement can lead to a lengthy reporting requirement each year.
Dispositions Require Reporting Capital Gains
Property is taxed under the capital gains framework of the IRC. Though stocks and bonds have their own IRC sections that lay out guidance for taxation, crypto assets have not been addressed by Congress in this manner. Crypto assets, for now, are lumped in with generic property assets.
There are three facts that a taxpayer must know prior to reporting capital gains: 1) basis in the asset, 2) price of asset at distribution, and 3) length of time the asset was held. A simple example is likely the best way to illustrate the taxation of crypto assets as property. Let’s assume a taxpayer buys 2 Bitcoin for $50,000 on August 2, 2020 and sells the 2 Bitcoin for $100,000 on May 20, 2021. The taxpayer would have a basis of $50,000 and a sell price of $100,000. The taxpayer’s gain would be $50,000. This gain would be taxable to the taxpayer in the year the asset was sold.
The tax rate for the gain is determined by the length of time the property was held. In the above example, the Bitcoin was held for less than one year. The $50,000 would be taxed as short-term capital gain or ordinary income. If the Bitcoin was held for longer than a year, the taxpayer would receive taxation under the long-term capital gains section of the IRC. Long term capital gains have a reduced tax rate.
This example is simple as it involves one crypto asset exchanged for USDs. Let’s tackle a more complicated, but common, situation. Let’s assume the taxpayer buys 2 Bitcoin for $50,000 on August 1, 2020. On August 2, the taxpayer exchanges the 2 Bitcoin for 250,000 Icon (ICX) tokens. On August 3, the taxpayer exchanges 100,000 Icon (ICX) tokens for 10,000 Balanced Tokens. On May 3, 2021, the taxpayer sells Balanced tokens for $50,000.
The taxpayer now has a difficult web to untangle to determine his tax liability for 2020 and 2021. The dispositions are as follows:
- Exchanging 2 Bitcoin for 250,000 Icon (ICX) tokens.
- Exchanging 100,000 Icon (ICX) tokens for 10,000 Balanced tokens.
- Selling 10,000 Balanced tokens for $50,000 USD.
Let’s start with the first transaction. The exchange of the 2 Bitcoin for Icon (ICX) requires the taxpayer to figure out the fair market value of Bitcoin on August 2 when the transaction occurred. If 2 Bitcoin was worth $48,000 on that day, the taxpayer realized a loss of $2,000 ($50,000 basis – $48,000 FMV at exchange date) in short term capital gains. The price per Icon (ICX) token was $.192 ($48,000 divided by 250,000 tokens).
The exchange of 100,000 Icon (ICX) to 10,000 balanced tokens is addressed next. The taxpayer’s basis in Icon (ICX) is $.192 per token. His basis in 100,00 tokens is $19,200. Now, he must determine the fair market value of the Icon (ICX) when sold. If on August 3 Icon (ICX) was worth $.25, his sell price is $25,000 (100,000 tokens at $.25 per token). The taxpayer would realize a short-term capital gain of $5,800 ($25,000 – $19,200) on August 3 when the disposition occurred.
The final transaction is more simplistic. The taxpayer obtained 10,000 Balanced tokens for $25,000. He then sold the balanced tokens for $50,000. The taxpayer would realize a capital gain of $25,000. Since the asset was held for less than a year, the gain would be taxed as ordinary income.
The above transaction sequence is a reality for many taxpayers that buy and exchange multiple crypto assets. For those that trade individual crypto assets with regularity, it is not hard to see how arduous the reporting requirements can become in a given tax year.
In Part Two of this post we will review IRS guidance on how a taxpayer should handle four crypto specific issues: 1) hard forks, 2) air drops, 3) Bitcoin/Ethereum mining, and 4) staking rewards.