IRS Evolves with the Crypto Market
The regulatory environment surrounding the crypto market is evolving yearly. As crypto assets become more common parts of investing portfolios, the federal government is attempting to clarify the requirements under various federal regulations. One of the most active areas is found under the tax rules within the Internal Revenue Code. Though the government has not created new rules directed at crypto transactions, they have consistently provided clarifications on how crypto transactions should be treated under existing rules.
For U.S. crypto investors, it is imperative to stay up to date on the IRS guidance. Taxpayers should seek out IRS rules, or the assistance from a tax professional, to ensure their tax filings comply with existing laws. The reality is nearly every crypto transaction, whether it be an airdrop, staking reward, crypto sale, or mining profits, are considered a taxable event under the ordinary income or capital gains rules.
Many long-term crypto investors interact with the market outside of known U.S. exchanges like Coinbase or Gemini. There is no central authority that issues a 1099-B or other tax form at year’s end to calculate their tax liability. Many of these investors have viewed the decentralized nature of crypto as a mask for their financial activity.
This common misconception should be countered as the IRS guidance becomes clear. At this stage of market acceptance, the federal government is knowledgeable about the various ways taxpayers interact with the market. They also understand losses in tax revenue from the crypto industry are unlikely to come from Coinbase or other exchanges where IRS forms are issued in January of each year.
With this backdrop, this post aims to lay out the current guidance from the IRS. This post is not legal or financial advice for taxpayers, but rather a central hub that will summarize current IRS guidance and provide links to relevant opinions. We strongly suggest that all crypto investors hire competent tax counsel to ensure the accuracy of their returns.
How Digital Assets are Defined under the IRC
The IRS defines digital assets as a “digital representation of value” on a blockchain or other cryptographically secured distributed ledger. The most common digital assets include convertible virtual currencies, stablecoins, and non-fungible tokens (NFTs). The IRS describes convertible virtual currencies as one that can be used to pay for goods or exchanged into fiat currencies or other digital assets. This definition is sweeping and covers nearly every crypto asset in the market today.
The Preliminary Crypto Asset Question on Form 1040
Starting in 2020, the government added a preliminary question to IRS Form 1040. The question requires the taxpayer to state whether they 1) received a digital asset or 2) sold, exchanged or disposed of a digital asset within the tax year. This question clearly aims to isolate those taxpayer that interacted with the market during a certain time frame.
The IRS guidance then offers examples of transactions that should dictate the taxpayer’s response. The examples draw a distinction between taxable and non-taxable events. The government advises taxpayers to check “yes” to the preliminary question if they: 1) received new digital assets as payment, staking rewards, or mining, 2) exchanged one digital asset for another or 3) sold a digital asset for fiat currency. The government advises that taxpayer’s should answer “no” if they: 1) did not own any digital assets, 2) did not have any digital asset transactions, 3) purchased a digital asset with fiat currency, or 4) only transferred digital assets between two wallets owned by the taxpayer.
The examples above make it clear what the government is looking for under this question. If the taxpayer answers yes, they had transactions with tax consequences. If they answer no, their digital asset involvement did not create any taxable events.
Record Keeping and Crypto Assets
Under the internal revenue code, the government requires all taxpayers to keep records of capital gains transactions. For investors in the stock market, this requirement is simple. The investor uses a broker like Charles Schwab to facilitate purchases and sales. The broker keeps comprehensive records of all transactions. Those records are then stripped onto a tax form for dissemination to the IRS at year’s end.
The process is similar for crypto investors who use a major U.S. exchange like Coinbase. Coinbase keeps track of all transactions and will deliver the appropriate tax forms at year’s end. However, the majority of crypto transactions are not conducted via Coinbase. And the exchanges/software used to facilitate the transactions is often not overseen by a central third party.
For these transactions, it is imperative the taxpayer keeps their own books to prove the substance of the crypto transactions. The taxpayer will need an accurate calculation of their basis in a particular digital asset and the proceeds from the sale. For a simple transaction, that process is straightforward. However, this process can become very complicated for active traders that are using decentralized exchanges and other mediums where records are not kept.
We have assisted multiple clients with analyzing their transaction histories years after the transactions were finalized. This process is time consuming and suffers from inaccuracies. It is nearly impossible to accurately track thousands of transactions from various wallets over a three-year span. There are too many pieces of different tokens being transferred to accurately compute the basis and proceeds from each sale. While there are software programs to assist in the process, it is much easier to stay on top of the data as it is produced.
Taxpayers who invest in crypto should strongly consider mapping out each transaction as it occurs. This ensures an accurate basis figure for a particular token, and ultimately, an accurate capital gain calculation for tax purposes. If the taxpayer waits until the end of the year, there will be inefficiencies in the process that may result in more taxes being paid than are actually owed.
On a side note, and importantly, the U.S. tax system does not operate like a court of law. The government does not have a burden to prove an actual gain amount. If the government’s calculations show a taxpayer owes $50,000 in capital gains tax, the burden shifts to the taxpayer to prove why they are wrong. If the taxpayer does not have records to show a more accurate figure, they will be stuck with the government’s calculations.
A taxpayer should not keep records just to satisfy the government’s requirements, they need to keep good records to ensure they are paying the correct amount of tax. As this area heats up in civil and criminal litigation, accurate records will become integral to positive outcomes. Taxpayers need to protect themselves in this emerging market. That protection starts with solid record keeping.
Taxpayers Need to Use the Correct Forms
As tax preparers and tax software services evolve with the market, the actual procedure for delivering capital gains and ordinary income on a tax return will become common knowledge. For now, many preparers and software programs are in the middle of the transition. This means that taxpayers need to ensure the information is going on the appropriate forms. The following details the form where certain crypto transactions should be declared:
- All sales of digital assets, whether they create a gain or a loss, should be reported on Form 8949.
- All income related to digital assets (staking rewards, mining, airdrops, hard forks, payment for services) should be reported as additional income on Schedule 1 of the taxpayer’s 1040.
- Any crypto assets that were given to another as a gift will trigger disclosure on Form 709 for gift tax.
- Any payments received for services rendered as a contract employee or through self-employment should be declared on Schedule C.
These general forms are well-known by CPAs and self-filers. However, there can be confusion when we attempt to apply the old rules to a new asset class. The IRS guidance helps clear up any confusion relating to the form that applies for each transaction.
IRS Notices, Private Letter Rulings, and Chief Counsel Advice
In addition to the general guidance, the IRS has issued more specific guidance through notices, revenue/private letter rulings, and chief counsel advice disclosures. These vehicles allow the IRS to deliver their position on specific tax questions. The following will lay out the various disclosures and the overarching interpretations that have emerged. Though these disclosures are not law in the United States, it does give powerful insight into how the IRS believes certain transactions should be dealt with under the IRC.
This IRS notice was the original clarification in the industry. Through this publication, the IRS notified taxpayers that virtual currencies were treated as property under the IRC and thus, were subject to income and capital gains rates. Further, the IRS clarified that crypto acquired through mining activities was to be treated as ordinary income and the basis in the token consisted of the tokens fair market value on the date of reception.
Under Revenue Ruling 19-24, the IRS reviewed whether hard forks and airdrops created taxable income to the receiver of the new tokens. They reviewed two separate scenarios: 1) a hard fork when no new token was created and 2) a hard fork where a new token was created and acquired by the owner of the original token.
Hard forks occur when an existing blockchain forks into another. These forks are done to either split off a new project or upgrade an existing one. When a hard fork occurs, the fork can create a new token that is disseminated to token holders of the original chain. Or it can create nothing new, and simply continue under the new chain’s protocols.
An example will likely assist in understanding this process. In 2017, Bitcoin underwent a hard fork. The fork peeled off a new chain called Bitcoin Cash. After the fork, there were two chains running in parallel, Bitcoin (unaffected) and Bitcoin Cash (a new chain). When the fork occurred, holders of Bitcoin (BTC) received equivalent value in the Bitcoin Cash (BCH) token. If a taxpayer held BTC when the fork occurred, he would hold that same BTC plus BCH tokens after the fork.
The question before the IRS was whether the taxpayer’s newly acquired BCH tokens were taxable as income under § 61. The IRS answered in the affirmative finding that the taxpayer received income at the market value of the BCH tokens when received. The continued holding of the BTC tokens did not create an accession to wealth and thus, there was no taxable income tied to BTC itself.
For example, let’s assume a taxpayer held 1,000 BTC in 2017 prior to the fork. Following the fork, the taxpayer held 1,000 BTC and 1,000 BCH. This taxpayer would have obtained ordinary income in the amount of the fair market value of 1,000 BCH on the day it was received. If the fair market value of BCH on the day the coins were acquired was $100 per BCH, the taxpayer received $100,000 in income on the date of reception. This fair market value would be ordinary income in the year received and the basis for capital gains calculations in the future.
This ruling is very important in the crypto industry as it provides a backdrop for how the IRS will treat numerous crypto transactions. The general rule is any accession to wealth in digital assets will be considered income, including staking rewards, air drops, mining, and other additions to a taxpayer’s portfolio. This is true regardless of the effort or work used to obtain the additional assets.
- The Chief of Counsel Releases
Following the revenue ruling and notice, the IRS has released various opinions from the office of chief counsel relating to specific transactions. Those opinions are summarized as follows:
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- Digital assets received for performing microtasks during crowdfunding campaigns are taxed as ordinary income. 2020-35011
- BCH received following the Bitcoin hard fork in 2017 is taxed as ordinary income as it involved an accession to wealth under § 61. 2021-14020
- Exchanges of Bitcoin for another digital asset is not a like-kind exchange, and thus, gains must be reported on the exchange/sale of the original asset. 2021-24008
- A digital asset that drops to nearly zero cannot be taken as a loss under § 165 (abandoned property) if it can still be technically traded on an exchange. 2023-02011
- A taxpayer must obtain a qualified appraisal on crypto assets that are donated as a charitable contribution exceeding $5,000. 2023-02012
- FinCEN Guidance with FBARs
In addition to the IRS, FinCEN has released guidance on virtual asset holdings. Notably, FinCEN advises that a taxpayer does not need to report a foreign exchange account holding virtual currencies under the current FBAR requirements. However, they have notified the public they plan to amend the regulation to include foreign exchange holdings. FinCEN 2020-2.
IRS Guidance is Evolving with Crypto Markets
Currently, the tax guidance on crypto assets consists of opinion letters advising taxpayers how the existing rules apply to the new asset class. In short, crypto assets are treated as property for income and gains purposes. All accessions to wealth related to the market create taxable income events that must be logged and disclosed on the returns.
It is important that taxpayers understand the existing rules of the playing field. Though interesting new questions are emerging each year, the IRS’s responses have been steady. There are no special rules for crypto assets. If you sell a digital asset, the gain/loss should be declared. If you receive crypto assets (that are not a gift), it is taxable income that should be disclosed. If you have any of these transactions, the taxpayer should advise the IRS under the preliminary question on their Form 1040.
Over the next four or five years, the government may promulgate new rules that directly relate to digital assets. Those rules may clarify the existing regulatory climate or make things even murkier for the average taxpayer. For now, taxpayers need to understand the existing expectations and ensure they are reaching out to competent counsel to ensure accurate filings.