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Cryptocurrency 101: What is cryptocurrency, exactly?
Cryptocurrency is a digital currency that uses cryptography for security. Examples include bitcoin (BTC) and ether (ETH). Cryptocurrency (or crypto) is decentralized, meaning it is uncontrolled by a central authority, such as a government or financial institution. Built on blockchain technology, a decentralized digital ledger records transactions across a network of computers, earning economic value for participants who secure the network. The use cases for certain blockchains or tokens vary, but many believe crypto is the future of finance.
Non-fungible tokens (NFTs)
NFTs are non-fungible compared to cryptocurrency which is fungible. NFTs often represent unique items on the blockchain, such as art, collectibles, and virtual real estate. NFTs gained popularity in 2021, with some selling for millions of dollars. The use cases for NFTs continue to evolve, and tax professionals must stay up-to-date on the latest guidance and best practices
Decentralized finance (DeFi)
DeFi refers to financial services built on blockchain technology and operates 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, with various products and services available, including liquidity pools, yield farming, and decentralized exchanges.
Liquidity pools are collections of cryptocurrencies locked in a smart contract, allowing users to trade seamlessly on decentralized exchanges.
Yield farming refers to the act of staking tokens in liquidity pools in exchange for interest — or yield — 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 trade-offs and risks associated with each approach.
Crypto tax basics
IRS guidance on virtual currency
The IRS considered all digital assets tangible personal property, per IRS Notice 2014-21. Since cryptocurrencies such as bitcoin are digital assets, they are also treated as property. Therefore, all the general property tax rules also apply to cryptocurrency.
Think of cryptocurrency as similar to a unit of stock. The amount you pay to obtain it establishes the cost basis. When you sell it, that creates sales proceeds. The difference between these two is a gain or loss.
Editor's Note: cryptocurrencies are not treated as currency for tax purposes. For more detailed information about why, please see key cryptocurrency-related terms in this recent article about the state of crypto and taxes in 2023.
In addition to Notice 2014-21, the IRS released Rev. Rul. 2019-24 and 46 virtual currency FAQs in 2019.
The revenue ruling addresses how to handle hard forks (permanent diversion 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 Notice 2014-21.
When are crypto transactions taxed?
For federal tax purposes, common taxable cryptocurrency transactions include;
- Selling cryptocurrency and/or NFT for cash (cashing out)
- Trading one cryptocurrency and/or NFT for another cryptocurrency (or NFT)
- Spending cryptocurrency for goods or services
- Earning cryptocurrency through staking, mining, rewards, or wages
- Receiving a new cryptocurrency as a result of a hard fork or an airdrop
Editor's note: for state-specific crypto tax information, including which states tax certain cryptocurrency transactions, see this recent article on cryptocurrency and state tax legislation.
Capital gains tax vs. ordinary income tax
Cryptocurrency disposal events — such as cashing out, trading one cryptocurrency for another, or spending cryptocurrency on goods or services — are generally subject to federal capital gains tax.
Cryptocurrency earnings (staking, mining, rewards, etc.) and receipts through hard forks and airdrops are subjected to federal ordinary income taxes.
2022 Form 1040 digital assets question
The IRS continues to refine and update the cryptocurrency question on Form 1040. In 2022, the IRS seems to be taking a more direct approach than in 2021 by further defining the terms used in the question.
There are three noteworthy changes in the 2022 question compared to the 2021 question.
- The IRS has broadened the scope of the question, replacing the words "virtual currency" with "digital assets."
Digital assets are any digital representations of value recorded on a cryptographically secured distributed ledger or any 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 clarified.
Receive now includes the receipt of rewards, awards, or payment for property or services.
- The somewhat ambiguous "financial interest in digital asset" term is clarified in the instructions.
The IRS now defines having a financial interest in a digital asset if someone is the owner of record of a digital asset, or has an ownership stake in an account that holds one or more digital assets, including the rights and obligations to acquire a financial interest, or owns a wallet that holds digital assets."
Taxpayers can safely check "No" to the cryptocurrency question in three situations, if digital assets were:
- Held digital assets in a wallet or exchange during 2022.
- Purchased using USD or fiat currency during 2022.
- Transferred between wallets/exchange accounts owned by the taxpayer during 2022.
Compliance challenges for tax professionals
There are several challenges that tax professionals face when reporting cryptocurrency transactions.
Lack of 1099-B reporting
Except for a few brokers like Robinhood, CashApp, Etoro & PayPal, the vast majority of US cryptocurrency exchanges do not issue any 1099-Bs for taxpayers. Moreover, annual gain & loss reporting is almost nonexistent in overseas cryptocurrency exchanges and decentralized exchanges. This shifts the burden of record keeping and computing annual gains & losses to tax professionals.
The Infrastructure bill required cryptocurrency exchanges to report proceeds and cost basis information to the IRS effective the 2023 tax year. However, the recent IRS announcement 2023-2 delayed the effective date of this reporting obligation. It is likely that the rule will go into effect for the 2024 tax year.
Multiple wallets & cost-basis tracking
If 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 challenging to manage the accounting method for disposals (FIFO, LIFO, or Specific ID) and track cost basis of each token and transaction.
The above compliance challenges can be overcome by using CoinTracker. CoinTracker is a data aggregation tool that connects with your clients' cryptocurrency exchanges & wallets and produces reconciled gain/loss reports for tax purposes. Without a tool like CoinTracker, it is virtually impossible to reconcile virtual currency transactions and generate accurate gain/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, being familiar with new developments such as NFTs & DeFi, and staying up-to-date on tax regulations and guidance.
Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional