Cryptocurrency tax rules can be confusing. The various types of cryptocurrencies (Bitcoin, Ethereum, etc.) often fall under a few different categories depending on interpretation. Property, ordinary income, securities, and collectibles each describe a type of cryptocurrency transaction, with its own tax and reporting consequences. Much needed clarity around these issues was provided when President Biden signed the Infrastructure Investment and Jobs Act into law. To help pay for the legislation, Congress set its sights on developing a uniform approach to cryptocurrency regulations. Many changes in the infrastructure bill will impact how cryptocurrency is taxed and regulated as soon as 2023. Understanding how transactions are taxed now, what needs to be reported, and what to look out for in the future can help Chicago businesses and investors stay ahead of changing rules. To help clients, prospects, and others, Selden Fox has provided a summary of the key detail below.
How Is Cryptocurrency Taxed?
Cryptocurrency, a form of virtual currency stored and secured on a blockchain, is treated as property for tax purposes. This means it is subject to capital gains and losses when exchanged for real currency. Like other property assets, cryptocurrency held for less than a year falls under short-term gains, which is then taxed at the ordinary rate. Cryptocurrency held for a year or longer falls under long-term capital gains, and is subject to either a 0%, 15%, or 20% tax, depending on the taxpayer’s income.
The amount of gain or loss is figured based on the basis. That is, the change in value from when the cryptocurrency was purchased or acquired to when it is exchanged or sold. In this way, cryptocurrency functions like securities and other tradable commodities. Taxpayers and investors must keep track of the basis on their own. They are still liable for any taxes even if they don’t receive a Form 1099.
Note that simply using cryptocurrency can trigger a tax liability. If a taxpayer uses cryptocurrency to buy something, they will owe taxes if the cryptocurrency value at the time of the purchase is more than what they acquired it for. In other words, if the taxpayer gets more value than what they initially put in, they will owe tax.
Cryptocurrency can also be used for other purposes, including but not limited to:
- Goods and services
- Wages
- Charitable contributions
- Purchasing digital assets (non-fungible tokens, or NFTs)
NFTs can be audio, video, graphics, or other digital files. Regarding taxation, buying or selling NFTs will trigger capital gains and can be treated as either property or collectibles. It is therefore important for taxpayers to monitor how long they’re holding cryptocurrency in a digital wallet. It may be worthwhile to hold onto an asset or hold off on a transaction until long-term capital gains would kick in. Timing, though one of the simplest strategies, can also be one of the most effective at managing tax consequences.
The good news is that certain cryptocurrency transactions are the same as with traditional currency. Charitable gifts and inherited assets are the same for tax purposes either way.
Hard Forks and Airdrops
Another potential tax consequence of cryptocurrency can occur when a blockchain changes, or forks. Forks can be either hard or soft. Soft forks don’t create any new cryptocurrency. As a result, they do not need to be taxed nor reported.
Hard forks, on the other hand, can result in new cryptocurrency on the blockchain, which generates taxable income. For example, Bitcoin rewrites the blockchain to add more security and privacy. The hard fork that is created with this new and improved protocol also triggers an airdrop and produces new Bitcoin on a new ledger. An airdrop, according to the IRS, is “a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses.” Previous Bitcoin remain on the legacy ledger while new Bitcoin are generated on the new ledger. That is a taxable event, and the account holder would need to recognize the new Bitcoin as taxable income when the hard fork and airdrop occur. The new Bitcoin would then be taxed at the ordinary rate.
The tax liability is based on the difference in value from when the hard fork occurred to when the Bitcoin on the old ledger was purchased or acquired; again, the cost basis. If a hard fork doesn’t create new cryptocurrency, then the account holder will not owe taxes.
Pending Reporting Requirements for Cryptocurrency Exchanges
Moving forward, how cryptocurrency is taxed won’t substantially change. What we do have now is clarity, thanks to the details contained in the Infrastructure Investment and Jobs Act. Starting in 2023, all digital assets will be treated the same as other securities, like stocks, bonds, and other commodities. Digital currency exchanges, like Coinbase or Robinhood, will be treated as brokers. That means they will be responsible for issuing cryptocurrency account holders Form 1099-B, the same form that traditional brokers issue to their investors.
It is likely that account holders will see discrepancies in reported capital gains because exchanges won’t have access to information about how much a cryptocurrency unit was worth when it was acquired. Without the basis, they will only be able to report on the value at the time of a sale or transfer. Thus, account holders will need to get in the habit of more closely tracking and recording this information on their own.
If cryptocurrency exchanges fail to send required forms once the regulations are effective, they will be subject to fines of up to $250 per customer, up to a total of $3 million. And of course, individual taxpayers are on the hook for actual reported gains or losses.
On top of that, cryptocurrency investors will be required to report transfers of $10,000 and above. These transfers will be treated as cash for tax and reporting requirements. In those cases, Form 8300 would be used to record and report the transaction. This particular provision has exchanges concerned, because if businesses are required to report $10,000 transfers – say, if an individual buys a Tesla with Bitcoin – that could expose the account holder’s credentials to unknown third parties.
What’s Next?
It’s likely the SEC will oversee regulatory enforcement. The Infrastructure Bill merely gave a blueprint for regulations; over the next two years, more guidance will follow clarifying these and other details. The new rules don’t take effect until January 1, 2023, which means the first 1099s won’t be issued until early 2024, unless exchanges decide to comply sooner.
Contact Us
The new regulations governing cryptocurrency reporting and taxation mean Chicago businesses and investors need to review their situation to determine how they will be impacted. Taxpayers still need to report certain cryptocurrency sales or transfers now; expect the IRS to crack down on underreporting. If you have questions about the information outlined above or need assistance with another tax or accounting issue, Selden Fox can help. For additional information call us at 630.954.1400 or click here to contact us. We look forward to speaking with you soon.
