Cryptocurrency: Individual Taxation & Reporting Obligations
While cryptocurrency has become a topic of increasing interest in recent years, it has disrupted the global financial system for over a decade. Bitcoin, the first cryptocurrency and current leader in market capitalization, was introduced back in 2009. In 2013, Ethereum introduced Ether, a decentralized finance token with smart contract functionality.
Fewer than 70 cryptocurrencies existed in 2013. Today nearly 10,400 are traded across native blockchain platforms. Cryptocurrency has become a popular investment strategy; however, investors need to understand how digital currency behaves as an asset, tax liability, and reporting obligation.
How does cryptocurrency behave as an asset?
Cryptocurrency is a volatile investment. At the close of 2019, the price of one Bitcoin was around $7,300. In November of 2021, the price of Bitcoin was at its highest at $64,400. As of the morning of September 14, 2022, the price of one Bitcoin was $20,339.80. At the close of 2019, the price of Ether was less than $130. Ether also reached its highest price in November of 2021 at $4,644.43. As of the morning of September 14, 2022, the price of Ether was $1,600.57.
When individuals buy digital currency on a trading platform, they may have the option to store the “keys” to their coins within the account of purchase; however, many individuals, especially those with multiple investments across several platforms, choose to store their cryptocurrency off-platform in a digital wallet. Some investors use the practice of staking to earn passive income, and they can earn rewards by locking up or delegating tokens in wallets for a specific period. However, this process produces interest-like income.
Cryptocurrency is not considered cash, so individuals cannot make contributions to an Individual Retirement Account (IRA) using cryptocurrency. On the other hand, IRAs are permitted to make investments, which means they may acquire cryptocurrency by purchase. When they have self-directed IRAs, individuals can include cryptocurrency in their retirement portfolios if the investments are made through LLCs that are 100% owned by the IRA. In this case, gains will be tax-advantaged because the retirement account will own the assets.
How does cryptocurrency behave as a tax liability?
Whenever an individual exchanges virtual currency for goods, services, or real currency, the exchange could create a tax liability. A tax liability occurs when the value of the good, service, or real currency realized for the cryptocurrency is greater than its cost basis put into the cryptocurrency. If the opposite is true, a tax loss is created. Generally, individuals must recognize capital gains or losses on Form 1040.
For tax purposes, the IRS treats cryptocurrency as property, so the realized change in the value of the cryptocurrency is subject to capital gains tax. Ordinary tax rates apply to short-term capital gains on assets held less than one year. Depending on the individual’s income, the ordinary tax rate could be up to 37% for 2022. Typically, long-term capital gains rates of 0%, 15%, or 20% apply to assets held longer than one year.
If a capital loss occurs, the individual can deduct the loss and realize a net loss of up to $3,000 each year. If their net losses exceed the limit, they must carry them over to the next year. A “wash sale” loophole exists for typical capital gains, which allows certain taxpayers to offset profits with losses. However, this does not apply to cryptocurrency, and Congress has been working to eliminate the loophole in the future.
In 2022, cryptocurrency gifts of more than $16,000 will be subject to federal gift tax. When the recipient of the gift sells it, their cost basis will remain the same as the gift giver’s cost basis. Inherited cryptocurrency will be subject to estate taxes in 2022 if the estate exceeds $12.06 million. The cost basis for the cryptocurrency will be stepped-up to the fair value on the day of death.
How does cryptocurrency behave as a reporting obligation?
Taxpayers are required to calculate their annual profits or losses across all cryptocurrency platforms and disclose whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during the tax year when they file Federal Form 1040. In addition, cryptocurrency transactions must be reported, even if the individual does not receive a tax form from the source.
Historically, cryptocurrency platforms and digital wallet software companies have not always supported proper accounting procedures to help individuals with year-end reporting. Recent legislation will require wallet developers, brokers, brokerage houses, and cryptocurrency miners to report cryptocurrency transactions and transfers of digital assets to non-brokers on Form 1099-B beginning on January 1, 2023.
Cryptocurrency transactions will undoubtedly be the focus of increased scrutiny from the IRS in the near future. The Inflation Reduction Act included a provision allotting $80 billion in funding to the IRS to update their systems and compliance enforcement efforts, including “digital asset monitoring and compliance activities.”
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by Maria Bunker, CPA
Maria Bunker, CPA, became a partner at Livingston & Haynes in 2017. She specializes in audits and tax planning and has worked with clients in diverse industries, including healthcare, financial services, real estate partnerships, and nonprofit organizations.