2021 Accounting Firm and Tax Practice Cryptocurrency Tax Guide
Cryptocurrency’s rising popularity, coupled with the high-profile inclusion of a virtual currency question on the Form 1040, has made cryptocurrency a must-know subject for tax professionals.
This guide will help tax professionals gain a foundational understanding of Cryptocurrency. Throughout the guide, I’ll provide a brief overview of cryptocurrency and discuss taxable transactions, implications of the Infrastructure bill, and how to serve clients with cryptocurrency successfully.
What are Cryptocurrencies?
In short, cryptocurrency is a form of digital money.
Cryptocurrency is similar to cash, such as US Dollars ($) or Euro (€), but exclusively digital, so there are no physical bills or coins. The first mainstream cryptocurrency was Bitcoin. Bitcoin was created by a pseudonymous person (or persons) called Satoshi Nakamoto in 2008. Since then, thousands of cryptocurrencies have emerged like Ether, Monero, Zcash, and more.
In addition to being completely electronic, cryptocurrency has another unique property compared to all other forms of money: it is not controlled by any central authority. In the Bitcoin white paper, Satoshi describes how the decentralized protocol works without governments, central banks, or financial institutions.
There are about 7,000 cryptocurrencies in circulation at the moment. You can see them and their live prices and other characteristics on www.coinmarketcap.com
How are Cryptocurrencies Taxed?
Cryptocurrencies like bitcoin are treated as “property” per IRS Notice 2014-21. Therefore, all the general tax rules applicable to property also apply to cryptocurrency.
Note: cryptocurrencies are not treated as a currency for tax purposes.
You can think of cryptocurrency similar to a unit of stock. The amount you pay to obtain it establishes the cost basis. When it is sold, sales proceeds are created. The difference between these two is a gain or loss.
Disposing and earning cryptocurrency result in taxable events. Common cryptocurrency-related taxable events include:
- Selling cryptocurrency for fiat currency (i.e.,USD, CAD, EUR, JPY, etc.)
- Trading cryptocurrency for another cryptocurrency (e.g., BTC for ETH, does not require cashing out to USD to be taxable)
- Using cryptocurrency to buy a good or service
- Earning cryptocurrency as wages, mining income, staking income, or interest income
- Receiving cryptocurrency as a result of a hard fork or an airdrop
The resulting gain/loss may be either capital or ordinary income, depending on the facts and circumstances of each case. For example, a cryptocurrency investor trading cryptocurrency would incur capital gains/losses. A cryptocurrency miner would report ordinary income equivalent to the fair market value of the coins mined.
Virtual Currency Question on Form 1040
The IRS has slightly changed the wording of the infamous virtual currency question on the draft 2021 Form 1040 published on July 21, 2021. The revised question only inquires about your taxable transactions compared to the much broader scope of the 2020 version.
The 2020 question reads, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?"
There are a couple of changes in the 2021 version. First, the IRS has removed the “send” piece from the 2020 version. Second, “acquire any financial interest” has been replaced with “disposed of any financial interest.”
Although these changes have no significant impact on your taxes, it hints at what the IRS has learned from the 2020 version and the direction it’s heading. At a high level, it looks like the IRS has narrowed down the scope of the 2020 question to only capture information about taxpayers with taxable cryptocurrency transactions.
Under the revised question, you don’t have to check “Yes” if you send cryptocurrency in between wallets/exchanges or if you acquire them. Those two actions are both non-taxable transactions.
Note: The 2021 Form 1040 is expected to go through several iterations before being finalized.
Infrastructure Bill & Cryptocurrency
Cryptocurrency was a controversial topic during the Infrastructure bill negotiations. Currently, cryptocurrency exchanges like Coinbase are not classified as brokers, and are not required to issue a Form 1099-B. The infrastructure bill brought cryptocurrency exchanges under the “broker” definition and subjected crypto transactions to the same information reporting requirements as stocks & securities.
As a result, effective as of the 2023 tax year, cryptocurrency exchanges will be re required to:
- Treat cryptocurrency as a covered security and issue a 1099-B, summarizing taxpayers’ annual cryptocurrency gains and losses
- Share cost basis information between cryptocurrency exchanges during transfers
The bill also requires businesses accepting cryptocurrency in excess of $10,000 to collect and submit the following Information:
- The name, address, and taxpayer identification of the person who paid to the business in cryptocurrency
- The amount of cryptocurrency received
- The data and nature of the transaction
Although the above provisions intend to make tax reporting easier for taxpayers and tax professionals, they may lack effectiveness in the crypto space. Due to decentralized protocols and self-custody assets, cryptocurrency exchanges will fail to capture accurate cost-basis information.
Many of these exchanges lack the necessary visibility into cost-basis information. This lack may be due to the assets not being purchased in the exchange, or because they were transferred in from another centralized exchange that does not shares cost-basis Information.
Regardless of the reason, incomplete & inaccurate 1099-Bs would be generated, requiring taxpayers to use external tools to track and reconcile cost-basis to avoid IRS trouble.
How to use CoinTracker
CoinTracker is a data aggregation tool that connects with your client’s cryptocurrency exchanges, wallets, blockchain, etc., and produces a gain/loss report for tax purposes. Without a tool like CoinTracker, it is virtually impossible to reconcile all the virtual currency transactions across multiple wallets and exchanges and compute taxable gains & losses.
Using CoinTracker with your client is an easy process:
- Direct your client to sign up for an account at CoinTracker
- Have your client connect read-only access to their crypto exchanges, wallets, and blockchains
- Have your client invite you to view their account so you can download the tax reports (Form 8949, Schedule D & Schedule 1)
Tax Planning Strategies
Cryptocurrency offers unique tax planning opportunities for accountants.
- Using CoinTracker and change the tax lot ID method to highest-in-first-out (HIFO) will result in the least amount of gains
- Cryptocurrencies are taxed as capital assets, making them eligible for a 0% long-term capital gains tax rate
- Donate appreciated crypto assets to qualified charities to bypass capital gain taxes and get a deduction on Schedule A
- Each quarter, evaluate your clients’ cryptocurrency positions and sell losing positions to harvest losses for tax purposes
- Trade cryptocurrency in a self-directed IRA to defer taxes
- Rollover unrealized cryptocurrency gains into opportunity zone
Cheatsheet for Accountants
- Don’t forget to ask the crypto question from your clients.
- The functionality of crypto is similar to stocks traded on a brokerage. The difference for crypto is that the wash sale rule does NOT apply.
- No 1099-Bs in this space (even if you see a 1099-B, it will show "missing cost basis"). You will only get 1099-K if you meet certain criteria.
- Cryptocurrency is treated as “property” for tax purposes (2014-21, 46 Q&As, 2019-24), and the result is capital gains & losses (Form 8949, Schedule D).
- Taxpayers need to reconcile gains/losses is easier with an automated tool like CoinTracker.
Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.