IRS increases cryptocurrency activity scrutiny, gives loss deduction and NFT tax treatment guidance
The IRS has been significantly increasing its scrutiny of cryptocurrency and other digital currency transactions in recent years, and this trend will accelerate this year and beyond. The agency is paying close attention to the tax implications of dealing in dealing in digital currencies, including non-fungible tokens (NFTs).
Among the ways the IRS is tracking individuals who engage in these transactions is by simply asking the question on form 1040. For the tax year 2020, form 1040 asked whether, at any time during 2020, the taxpayer received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. There were 164,358,792 1040 returns filed in 2020, and the responses broke down as follows:
- Yes: 2,226,516
- No: 147,171,652
For the 2022 tax year, the IRS broadened the question, and many more taxpayers are expected to respond yes, as I discussed earlier this year: IRS requires all taxpayers to answer digital assets question on 2022 FY Form 1040s.
How is cryptocurrency treated for federal tax purposes
Cryptocurrency is treated as property for tax purposes, meaning that gains or losses from its sale or exchange are subject to capital gains tax. This means that individuals who sell their cryptocurrency or NFTs for a profit must report the transaction on their tax returns and pay taxes.
Our AnswerConnect team recently published a deep dive into virtual currencies, cryptocurrency, and state taxes, including which states tax digital assets and/or virtual currencies.
Cryptocurrency tax enforcement
As one tool to help enforce compliance with these rules, the IRS is using form 1040 to track individuals who deal in cryptocurrency and NFTs. The current version of the form includes a question about virtual currency, specifically asking if the taxpayer received, sold, sent, exchanged, or otherwise acquired any financial interest in virtual currency during the 2022 tax year.
In addition, the IRS is working with blockchain analytics firms to identify individuals who may be evading taxes by using cryptocurrency to hide their income.
Advice Memorandum on deducting cryptocurrency losses
Recently, the IRS released a Chief Counsel Advice Memorandum (CCA 202302011). The memo states that taxpayers cannot claim a deduction for cryptocurrency losses that – absent a sale or other taxable disposition – substantially declined in value if the cryptocurrency continues to trade on at least one cryptocurrency exchange and has a value greater than zero.
In addition, the guidance states taxpayers who purchased cryptocurrency for personal investment and had cryptocurrency losses because of worthlessness or abandonment couldn't deduct the losses. This impacts taxpayers for tax years 2018-2025 due to the limitations on miscellaneous itemized deductions.
The guidance also clarifies several key issues related to the taxation of digital currency assets, including the definition of "virtual currency," the tax treatment of hard forks and airdrops, and the tax implications of holding digital currency in a foreign account.
It defines virtual currency as "a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value." This definition is similar to the one used by the Financial Crimes Enforcement Network (FinCEN), a bureau of the US Department of the Treasury.
The guidance also clarifies the tax treatment of hard forks and airdrops. A hard fork occurs when a blockchain splits into two separate chains, while an airdrop occurs when a person receives cryptocurrency for free, typically as a result of holding another cryptocurrency. It states that the tax treatment of these events depends on each case's specific facts and circumstances.
Finally, the Memorandum provides information on the tax implications of holding digital currency in a foreign account. Specifically indicating that US taxpayers holding digital currency in a foreign account must report the account on their tax return and may be penalized for failing to do so.
Preliminary guidance issued on tax treatment on NFTs
On March 21, 2023, the Internal Revenue Service issued preliminary guidance Notice 2023-27 on the tax treatment of non-fungible tokens (NFT), digital collectibles. The agency also asked for feedback for upcoming guidance on these digital assets.
Until additional guidance is issued, the IRS stated it intends to determine when an NFT is treated as a collectible by using a "look-through analysis." Under the look-through analysis, an NFT is treated as a collectible if the NFT's associated right or asset falls under the definition of collectible in the tax code. For example, a gem is a collectible under section 408(m); therefore, an NFT that certifies ownership of a gem is a collectible.
An NFT is a unique digital identifier recorded using distributed ledger technology and may be used to certify the authenticity and ownership of an associated right or asset.
Distributed ledger technology, such as blockchain technology, uses independent digital systems to record, share and synchronize transactions, the details of which are recorded simultaneously on multiple nodes in a network.
A token is an entry of data encoded on a distributed ledger. A distributed ledger can be used to identify ownership of both NFTs and fungible tokens, such as cryptocurrency, as described in Rev. Rul. 2019-24.
Clearly, individuals who engage in cryptocurrency transactions, including NFTs, should be aware of the tax implications of their activities. The IRS closely monitors these transactions and uses form 1040 and other methods to track individuals who engage in them.
The IRS Chief Counsel office's recent memo clarifies several key issues related to the taxation of digital currency assets.
The preliminary guidance issued by the agency on March 21 treats NFTs as collectibles based on Internal Revenue Code section 408(m), which defines a collectible as "any tangible personal property which is capital gain property and which is held by the taxpayer for more than 12 months primarily for the appreciation of its value."
The IRS's guidance means that NFTs will be subject to a 28% capital gains tax rate when they are sold. This is higher than the 15% capital gains tax rate that applies to most other types of assets.
Some believe that NFTs should not be treated as collectibles because they are not tangible personal property, and many expect this treatment will face a court challenge. In any case, this guidance is preliminary, and we can expect further word on this from the IRS in the coming months.
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