Tom Talks Taxes - April 8, 2022
All tax professionals need to understand basic cryptocurrency tax rules
I have a small tax practice because my time is now focused on tax education. My annual tax preparation clients are a group I have carefully selected over time because we collectively work well together.
This is the first year I got the “oh, I started doing crypto stuff” in response to the “Did you own cryptocurrency at any time during the year?” question on my intake checklist.
This situation, in addition to comments from colleagues, leads me to believe that this is the first tax season where cryptocurrency has gone sufficiently mainstream that it will touch almost every tax practice. At this point, every tax professional needs a basic understanding of the taxation of cryptocurrency transactions.
Don’t get me wrong: I’m not saying tax professionals should be able to handle every cryptocurrency transaction. You need to know enough about the topic to identify when there is a potential reporting issue, understand how a basic transaction is treated for tax purposes, and when the situation exceeds your comfort level such that referral to a cryptocurrency tax specialist is in order.
If your client uses a third-party software solution to analyze the transactions, then you still need sufficient knowledge to review the output and confirm that it appears correct, consistent, and complete with your understanding of the taxpayer’s cryptocurrency activities. It is inadvisable to blindly rely on self generated reports: as the old saying goes “garbage in, garbage out.”
If you don’t have that requisite level of knowledge, then focus your continuing education post-tax season to gain competency. Cryptocurrency is not going away; if anything, it will be more prevalent in your tax practice each year going forward.
Complicating matters further is the limited guidance issued by the IRS on cryptocurrency taxation, and what has been issued is always a year or two behind industry developments. The courts have yet to rule on any cryptocurrency tax issues.
Here is the cryptocurrency-related tax guidance we have as of now:
Here is a distillation of the basic principles of cryptocurrency taxation from the above:
Cryptocurrency is property for federal tax purposes. The sale or exchange of cryptocurrency generates capital gain or loss provided it is a capital asset to the owner.
Example: Paul sells 0.1 BTC that he held for more than one year for $4,200 cash. His adjusted basis in the 0.1 BTC is $1,200. Paul recognizes a long-term capital gain of $3,000.
Exchanging one cryptocurrency for another is a taxable transaction. An exchange of one cryptocurrency for another is a taxable disposition for federal tax purposes. The gain or loss is equal to the fair market value (FMV) of the cryptocurrency received less the adjusted basis of the cryptocurrency given up. See Treas. Reg. §1.1001-1(a).
Example: Paul exchanges 0.1 BTC that he held for more than one year for 1.29 ETH with a FMV of $4,200. His adjusted basis in the 0.1 BTC is $1,200. Paul recognizes a long-term capital gain of $3,000, and his adjusted basis in the 1.29 ETH is $4,200.
Receipt of cryptocurrency is ordinary income unless otherwise excluded. A taxpayer recognizes ordinary income equal to the FMV of the cryptocurrency received unless a tax law provision excludes it. Gross income includes all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion. See §61(a)(3) and Comm. v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). This includes, for example, cryptocurrency received in either a hard fork or from mining activities. A common income exclusion that can apply is the gifting of cryptocurrency, which is excluded from a taxpayer’s income under §102.
Example: Norton Crypto allows individuals to mine ETH when their computers are idle. The software handles it all; the taxpayer has no involvement except consenting to the activity on the already installed anti-virus software. Paul activates the program and mines 0.015 ETH with a FMV $49. Paul recognizes $49 of ordinary income.
Receipt of cryptocurrency in a trade or business is subject to self-employment tax. If a taxpayer receives cryptocurrency in a trade or business subject to self-employment tax, then the FMV of the cryptocurrency is subject to both income tax and self-employment tax. If the taxpayer is engaged in a cryptocurrency-related activity, such as mining, then the net income of the activity is subject to self-employment tax only if the activity rises to the level of a §162 trade or business. An activity is a §162 trade or business if the activity was conducted with continuity and regularity for the primary purpose of earning income or making a profit. See Comm. v. Groetzinger, 480 U.S. 23 (1987).
Example: Paul is a self-employed tax accountant and receives 0.1 BTC with a FMV of $4,200 from Lyla in full satisfaction of Lyla’s invoice for services provided. Paul recognizes $4,200 of ordinary income subject to self-employment tax. If Lyla’s adjusted basis in the 0.1 BTC is $1,200 and she held it for more than one year, then Lyla recognizes a $3,000 long-term capital gain upon transfer.
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