As if the steady decline in the value of cryptocurrencies since the beginning of 2018 wasnt bad enough, investors are now faced with the challenge of navigating the minefield that is filing taxes on their crypto assets.
Though we recently passed the ten-year anniversary of Bitcoin, tax authorities (both in the U.S. and abroad) have a lot to catch up on where issuing guidance is concerned. In spite of growing interest in Bitcoin by major financial players like hedge funds and banks, in addition to retail investors, the regulatory landscape hasn’t adapted to accommodate the burgeoning crypto asset class.
Efforts so far have largely sought to simply shoehorn cryptocurrency guidance into existing frameworks, with little regard for the specifics of how they function or the unique traits that set them apart from other assets covered by regulations.
First and Foremost – For Taxes, Crypto is Property
The IRS qualifies Bitcoin and other convertible virtual currencies as property for the purposes of taxation, meaning that they should not be treated like a traditional currency. Taxable events can be triggered by a number of actions – selling for fiat and trading for other cryptocurrencies, but also for purchases of goods or services with the asset. Some activity is exempt from taxation. Transfers from wallet-to-wallet, wallet-to-exchange, etc. do not result in a taxable event. Gifts may also be exempt from tax provided they fall within the rules of IRS Form 709 United States Gift (and Generation-Skipping Transfer) Tax Return. Charitable donations under the gift thresholds may also be tax free and have an added benefit of reducing your income by the appreciated value of the asset. For example, if the gift threshold for which no tax is required is $15,000/year and you purchased $1,000 worth of crypto which appreciated in value to $15,000 and donated it to a qualified charity, you can claim a $15,000 deduction and pay no tax on the $14,000 gain.
Detailed record keeping is key. For every digital asset owned, investors should be logging the entire life-cycle and its not as simple as it may appear. The actual value received (or its fair market value in the case of mining) must be tracked as the asset moves from exchange to wallet, to another wallet, back to an exchange, and finally disposed of in a sale or payment. Life-cycles may be very short or often times very complex involving multiple stops with network and exchange fees chipping away at its value.Such record keeping is crucial in order to later calculate their gains/losses, and ensure that the correct tax is being paid. Fortunately, software can handle this for you.
Different investors evidently have different models – someone who bought one Bitcoin in 2010, held it and sold it in 2019 will have a much shorter paper trail than a day trader that executes hundreds of trades per day. For the latter, its highly advisable that they seek out some of the crypto-oriented software solutions on the market today, which are able to extract historical data from multiple exchanges and perform all of the relevant calculations automatically.
Offsetting is Your Friend
Many investors dont realize that theres a silver lining in their paper losses (58% of investors, according to a recent study by Credit Karma): if an investor is currently in the red – given the state of the markets, and they most likely are, they can realize the loss and report it as such (using IRS Form 8949). What this means is that gains made on better performing assets can be offset.
Consider the case where you buy cryptocurrency at $4,000 that later drops in value to $2,000. Also in your portfolio is a stock that you purchased at $3,000, which appreciated to $5,000. Instead of holding the cryptocurrency and paying capital gains on your stock profit of $2,000, the cryptocurrency can be sold for a loss. The loss incurred results in a net gain of $0, so nothing is owed.
Note however, that once you file taxes on cryptocurrencies losses, youll need to file them on gains to avoid the risk being penalized for failing to report in the future.
Forks and Airdrops
Two mechanisms unique to blockchain-based currencies are hard forks and airdrops. The former occurs when the network diverges from the original chain, leaving holders of a given coin with a corresponding amount on the new chain – see the Bitcoin/Bitcoin Cash split in 2017. With airdrops, nominal amounts of cryptocurrency are distributed to seemingly random addresses or to addresses controlled by investors who have opted-in.
Experts are divided on how to proceed after these events. A number believe that gains should be taxed contingent on the value of the assets on the date of the fork. However, this makes little sense, given that some investors may have no interest in ever accessing forked/airdropped coins, nor did they opt in to receiving them in the first place. A more prudent approach would be to simply assume a cost basis of $0, and to report 100% gains when theyre disposed of.
1099-K vs 1099-B Reporting
Theres a lot of confusion over which IRS form is best for reporting activity on cryptocurrency. Last year, and probably this year, Coinbase issued 1099-K forms to their users, but its relevance is questionable – after all, its traditionally used for payment cards and network transactions. An argument could be, and has been, made for their use in relation to cryptocurrency, it doesnt seem to align well with the property guidance, particularly when compared to the 1099-B, which deals with broker/barter exchanges and specifically property. While receipt of 1099-K or 1099-B is entirely out of an individual’s control, its recommended that investors speak with a proficient accountant or tax attorney if either one of theses forms is delivered to understand how to read or dispute it..
Record, Record, Record
The IRS needs to address the lingering ambiguity surrounding the taxation of crypto assets, so as to encourage greater transparency and cohesion between regulators and investors. While awaiting this, two practices are critical: a) seeking out advice on how to correctly file cryptocurrency-related taxes and b) meticulously record every transaction, from purchases and trades to wallet-to-wallet transfers. As it stands, the burden is on the investor to defend their tax positions.
The most ironclad method of assuring this is equipping oneself with tools that remove human error from the equation and ensure uniform and consistent treatment: software solutions that integrate with exchanges and wallets and provide easily-accessible insights into investments, ensuring that every investor is able to present clear paper trails to auditors.
About The Authors
Sean Ryan and Perry Woodin, are the Founders of NODE40. NODE40 Balance is a robust cryptocurrency reporting software that integrates directly with major cryptocurrency exchanges.
