Cryptoassets like Bitcoin and NFTs are becoming a part of many client portfolios. With recent volatility in the markets, it is important to get ahead of potential issues now. With the growing popularity of crypto, it is safe to say that going forward crypto will be an area of growth for accounting practices.
The crypto ecosystem is rapidly evolving beyond currencies into other corners of the finance industry. For instance, anyone can add cryptocurrency to a liquidity pool and receive income from transaction fees. Others might purchase a non-fungible token representing a collectible piece of digital art or an item in a play-to-earn game.
Despite this evolution, the Internal Revenue Service continues to provide scant guidance to taxpayers. The agency’s last major update was back in 2019 when it issued new guidance on cryptocurrency forks, valuing cryptocurrency received as income, and calculating taxable gains. Since then, some taxpayers have turned to the courts to clarify laws (e.g., Jarrett v. United States).
The good news is that there are some steps that your clients can take to avoid any problems with the IRS and minimize their tax exposure.
Carefully track transactions
The Infrastructure Investment and Jobs Act requires cryptocurrency exchanges to issue 1099-B forms to their customers and the IRS beginning in 2023, reporting fiat proceeds from transactions.
Since cryptocurrencies are commonly sent between wallets and exchanges, many exchanges don’t know their customers’ true cost basis. For instance, if a client transfers $10,000 from their personal wallet to an exchange and then sells it, the exchange would likely report the $10,000 in proceeds and leave the cost basis blank.
As a result, it’s critical that taxpayers keep a detailed record of their transaction history across all wallets and exchanges. This is often impossible without using specialized software if the client has more than a few accounts and thousands of transactions. Without defensible records in place, the IRS may assume that all proceeds made from cryptocurrency disposals are income. These assumptions may trigger warning letters (as they have in the past) or even an audit.
Angel Garcia/Bloomberg
A big year for tax-loss harvesting
Cryptocurrencies have had a wild ride over the past year. After reaching a market capitalization of nearly $3 trillion in late 2021, the market fell to $850 billion by mid-2022, leaving many investors with steep losses.
Taxpayers who take proactive action have an opportunity to harvest cryptocurrency tax losses and lock in offsets for their 2022 capital gains and income. Unlike equities, cryptocurrencies aren’t subject to the wash sale rule, meaning you can deduct up to $3,000 against your taxable income and carry forward any further losses into future years.
The only catch is that the IRS could require that transactions have “economic substance” to be eligible for tax benefits. As a result, taxpayers may want to wait a few days before repurchasing cryptocurrencies after harvesting losses.
Writing off scams and theft
The collapse of Luna and other less-prominent cryptocurrencies will inevitably have many taxpayers asking about other potential write-offs. After all, unlike tax-loss harvesting, write-offs have no $3,000 deduction limit.
The IRS requires an investment to be completely worthless before taking a full investment write-off. While Luna fell substantially lower, it still has some value (and the project owners plan to keep it alive). Claiming a full write-off may also require sending the cryptocurrency to a so-called “burn wallet” to completely destroy it.
The news is even worse for stolen funds. The 2017 Tax Cuts & Jobs Act removed the ability to write off losses from stolen cryptocurrency. That means investors cannot write off losses from hacked crypto exchanges, stolen wallets, or physical theft or loss. As a result, taxpayers may want to consider implementing security measures and crypto insurance.
Dealing with ongoing ambiguities
With a lack of regulation and tax guidance, accountants and advisors are left to make educated guesses based on client preferences and then hope for the best.
NFTs have become popular among collectors, but there is a lot of uncertainty surrounding their tax status. For instance, artistic NFTs could be classified as collectibles and subject to a higher 28% tax rate than the conventional 20% capital gains tax rate. That said, the difference between art and in-game items is ambiguous.
Decentralized finance, or DeFi, ecosystems are more complex. For example, putting crypto up as collateral is not taxable, but if you choose to receive collateral back as a different coin, it may be a taxable event. If you earn staking rewards or receive governance tokens, the IRS may classify these tokens as ordinary income.
The bottom line
Cryptocurrencies could become a headache for accountants over the coming years. With the market moving significantly lower, taxpayers could have an opportunity to harvest tax losses and offset their income. New reporting rules make it imperative to track every transaction to come up with a defensible cost basis. And the lack of clear guidance leaves a lot of other issues up to taxpayers’ discretion.
