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Year-End Crypto Tax Planning

Industries: Technology

Services: Tax

By: Matt Lynch

Cryptocurrencies, tokens, NFTs, and digital assets of all types have had a meteoric rise in the last year.  Last Thanksgiving, the price of a Bitcoin was close to $17,700.  Fast forward to Thanksgiving 2021, and the crypto space has seen a lot: Bitcoin topping $67,000, joke coins named after dogs reaching $30,000,000,000 market caps, and even a digital picture of a cartoon monkey (an NFT) selling for over $2,000,000.  It’s been quite a year for digital assets.

Whether you view these digital asset classes as the 21st century equivalent of the Dutch “tulip mania” or think that blockchain technology is the transformative technology of the future, there is no debate that a lot of money has been made and lost by many.  Even less debatable is the fact that the IRS is aware of this and will be looking for its cut of the profits.

As 2021 comes to a close, it’s important to take a step back and consider the tax implications of all of these transactions during the year.  For many, 2021 was the first year that crypto went “mainstream” and seemed like an investable asset class.  What many will not realize, is that unlike investments handled by a brokerage, tax reporting forms will likely not be provided to you to hand off to your CPA.

Talk to Your Tax Advisor Now

Tax advisors have a very difficult time planning for things they don’t know about.  As silly as it may be to talk about the gains and losses you have from your Shiba Inu coin or the airdrop of MOONSHIP coins that you received randomly, these are important conversations to have now before the end of the year.  Planning before year-end can make sure there are no surprises in April.

No Cash – No Tax – Not True

A misconception among digital asset-holders is that if gains haven’t hit a bank account in the form of U.S. dollars, then there is no tax to pay.  This is incorrect.  The IRS guidance we is very clear on this issue: Any sale or exchange of a digital asset is a taxable event, whether you exchange it for another coin, U.S. dollars, stable coin (a coin pegged to a U.S. dollar), NFTs, or goods or services.  An airdrop, or the receipt of a digital asset (usually for free) in a wallet you control, also potentially trigger a taxable event.  Based on limited IRS guidance, it appears that airdrops received are taxable based on the fair market value of the airdrop at the date it was received.  Similar taxable treatment is applied to assets received via hard-forks.

Can Hack It – Can Track It

Another common misconception held by digital asset-holders is that there is total anonymity in this new digital frontier.  While Bitcoin may have been anonymous in its early days, those days are likely far behind us.  In 2016, the IRS issued a John Doe summons to Coinbase to investigate tax non-compliance.  It sent over 10,000 letters to taxpayers who had not reported gains and losses.  Once the IRS has obtained exchange records, the audit trail to a taxpayer’s wallet is easy via a fully verifiable, publicly-accessible blockchain.  It’s also noteworthy that the IRS is now a major digital asset-holder, with more than $1,200,000,000 seized in 2021 alone.  The IRS is spending a lot of resources on digital assets and to underestimate them is likely a mistake, potentially a mistake that could have criminal consequences.

Records

If you held your assets only on a single exchange, you will likely be able to get the information you need for tax reporting from that exchange.  If you pursued unique coins that were only available on exotic or decentralized exchanges, then proper recordkeeping is key.  There are many applications that will sync to different exchanges and wallet types that can help consolidate your transactions.  Talk to your advisor about different options and then do your own research to see which one supports the exchanges and wallet types you have.

Loss Harvesting and Wash Sale Rules

Loss harvesting is the idea of “selling losers” and recognizing losses to offset other gains recognized in the current year.  One major hurdle to loss harvesting is wash sale rules, which disallow losses on a security if the security is repurchased within 30 days.  Currently, wash sale rules do not apply to digital assets.  A sale and subsequent repurchase of the same asset could free up losses that could offset other gains you may have, without having to reduce exposure to that asset for a typical 30-day period.  It’s important to note that pending federal legislation includes language that would subject digital assets to wash sale rules moving forward. 

Crypto IRAs

If you are considering buying digital assets, a self-directed IRA could be a tax-efficient way to do so.  Although the steps involved in a self-directed IRA are typically more cumbersome than a normal IRA offered through a broker, the ability to exchange digital assets without triggering taxable gains could be worth the hassle.  Self-directed Roth IRAs are also a possibility.

NFTs

An NFT is a “non-fungible token,” or for purposes of this article, pieces of digital art stored on a blockchain.  The NFT space is even more novel than the cryptocurrency space and brings a new set of tax issues that have not yet been addressed by the IRS.  In the absence of guidance, reliance on parallels to established tax concepts is key.  What some in the tax world have suggested is that the purchase of a digital piece of art may be treated as if you purchased a piece of art for your own home.  No matter how expensive or valuable a piece of physical art may be, if you use it for personal use and not strictly as an investment, generally a loss on the art would be disallowed.  Additionally, gains on art used for personal use are typically taxed at higher “collectible gain” rates, currently 28%.  Keep these concepts in mind before you use an NFT as your digital avatar or profile picture.  Also remember that the purchase of an NFT also triggers gain on the cryptocurrency used to purchase it.  

Next Steps

As always, the advisors at HPG are here to help you with any tax situation that arises, whether it’s in the real or digital world.  This digital asset space and the regulations surrounding it are constantly evolving.  While nobody knows what future tax law changes may bring, discussion and planning now can help put you in the best possible position and avoid costly surprises down the road.