The cryptocurrency, “crypto” hereafter, market has been a roller coaster for most of 2020, with Bitcoin leading the way.
While the markets crashed in a similar fashion as the stock market in March due to the COVID-19 pandemic, they’ve come roaring back toward the end of 2020. Bitcoin even hit an all-time high in early January of over $40,000 per Bitcoin. In 2019, the IRS added a question to Schedule 1 asking, “Did you receive, sell, send, or exchange, or otherwise acquire any financial interest in any virtual currency?” The IRS has now moved this question to Page 1 of Form 1040 on the 2020 tax return in effort to make it more visible, as it continues to target crypto.
While crypto is starting to become more widely used, it’s important to understand the various tax implications. In Notice 2014-21, the IRS has declared that crypto will be treated as property. Being treated as property means it’s treated similarly to stocks. This means that upon selling crypto for cash, trading for another crypto, or spending it on goods or services, a capital gain or loss will be realized. These are the most common taxable transactions and will be reported on Form 8949 and Schedule D. Information including the date acquired, date sold or traded, gross proceeds (fair market value), cost basis, and gain or loss will be reported. If crypto is held for a year or more, it qualifies for long-term capital gain treatment. This is important because under current tax law, beneficial tax rates are offered on long-term capital gains with a maximum tax rate of 20% compared to the highest tax rate on ordinary income of 37%. Taxpayers may want to consider that only $3,000 of net capital losses can be taken each year, while any amount exceeding $3,000 will be suspended and utilized in future years.
With all that being said, one of the keys for tax reporting is being able to identify the cost basis of each transaction. There are a few different scenarios of how the cost basis is determined. The most common scenario being that the cost basis is the amount initially paid for the crypto when purchased from an exchange. Another scenario would be if you were to receive crypto in exchange for performing services or you received it from an Airdrop. In this scenario, the fair market value (in USD) of the crypto received would need to be included as ordinary income in the year received. This amount then becomes the cost basis when it is eventually sold, and a gain or loss will be realized. It is recommended that the first-in, first-out (FIFO) method of accounting be used in reporting disposals of crypto.
The unfortunate part about crypto compared to stocks is that you will not receive accurate year-end tax reports, like 1099s for example. Exchanges can send year-end reports, but since crypto can be transferred to other exchanges or wallets, which is a nontaxable event, the exchanges are unable to provide accurate information detailing the original cost basis. This becomes a big problem and ultimately means that record-keeping is absolutely essential and becomes the responsibility of the taxpayer. While taxpayers in most cases can track this information down on whichever exchange they prefer to use, it can be a strenuous process especially for high-volume traders.
A potential tax planning opportunity or crypto “loophole” that everyone should be aware of is related to wash sales. A wash sale is when a security is sold at a loss, but then the same security or “substantially identical security” is purchased within 30 days of the sale. If this were to happen with a stock, taxpayers can’t use a capital loss from this transaction. However, with crypto being treated as property, and not considered a security, it is not subject to wash sale rules. This can be extremely valuable for tax purposes in times when your positions have gone down in value.
Please contact your Schneider Downs tax advisor if you have any questions or would like to discuss the tax implications of crypto currency transactions in further detail.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.