Cryptocurrencies, or as the IRS calls them, “virtual currencies,” are taking the world by storm. More and more investors are eagerly seeking to capitalize on the volatility of the crypto market and make a return on their investment. That said, investors need to be wary of federal agency approaches concerning crypto investments as well as whether their activities trigger any crypto tax reporting obligations.
5 Tax Tips for Investors in Cryptocurrencies
Investors need to be well versed on the history of IRS guidance and releases on virtual currencies.
IRS guidance on “virtual currencies” dates back to 2014. In 2014, the IRS released its Notice 2014-21, which clearly asserts that virtual currency transactions will be treated as property for federal income tax purposes. When defining the purpose of virtual currency, this Notice describes a virtual currency as a digital representation of value that can one or more of the following purposes: (1) medium of exchange; (2) unit of account; and (3) store of value.
When the IRS started to realize that the nation was facing a significant underreporting problem concerning virtual currencies, it issued a reminder bulletin to U.S. taxpayers in 2018. This bulletin urged taxpayers to report their virtual currency transactions or be subject to criminal charges. In 2019, the IRS issued the release, IR-2019-132, where it noted how the agency had sent out over 10,000 letters to taxpayers for failing to report all their virtual currency transactions or for inaccurately reporting such information. Finally, starting in the tax year 2019, the IRS added a very specific question to Form 1040: “At any time during [the taxable year], did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?”
Various cryptocurrency transactions trigger tax reporting requirements, sometimes both at the time of receipt and the time of sale or disposition.
Before investing large amounts in cryptocurrency and then exchanging, selling, or disposing of them in the hopes of making a profit, investors need to understand that such actions trigger tax liability and reporting obligations. Depending on the type of cryptocurrency, or “virtual currency” transaction, this could mean creating a taxable event that produces either ordinary income or capital income. In addition to the obvious reporting obligations incurred for selling or exchanging virtual currencies, other activities such as selling or receiving airdrops, income from initial coin offerings (“ICOs”), or mining coins also create tax reporting obligations.
On that note, cryptocurrency mining is a special topic. Crypto mining triggers two taxable events. The first tax event occurs when the taxpayer mines the cryptocurrency, thus receiving a new coin as the reward for being the first to successfully verify the transaction. This is reported as ordinary income. The second tax event occurs when the taxpayer decides to sell, exchange, or otherwise dispose of this cryptocurrency at a later time. This is reported as capital gains or losses and may be short-term or long-term, depending on how long the taxpayer held the cryptocurrency. Lastly, individuals that engage in mining as a business can take the usual business deductions under Section 162 of the IRC.
The crypto tax reporting process for crypto investors is both nuanced and dependent on multiple factors such as business type, hobby versus business income, and filing status.
Reporting one´s virtual currency transactions involves multiple forms and several steps. The first question one has to ask is whether they actually engaged in a virtual currency transaction. If you did, the next question is whether those transactions are ordinary or capital in nature. Answering this question involves examining the purpose of the transaction, the nature of the transaction, and the holding period. For instance, income from ICOs is ordinary, while the sale of cryptocurrencies that were held for over a year is capital. After the taxpayer determines the holding period, the transactions are netted, and the taxpayer completes IRS Form 8949—Sales and other Dispositions of Capital Assets. The amount of the taxpayer´s capital gains and capital losses—including from cryptocurrency sources—is also transferred to Form D. If the taxpayer has any virtual currency transactions that resulted in ordinary income, this is also reported, but the form used may differ (Schedule 1 for hobby income; Schedule B for interest earned; and Schedule C for businesses). Without proper guidance from a tax attorney or CPA experienced in virtual currency reporting, this process can be very cumbersome.
The IRS may initiate criminal proceedings against individuals and investors for failing to report or falsely reporting “virtual currency” transactions.
The IRS has recently increased its efforts to investigate and refer to criminal prosecution individuals that are engaging in criminal tax fraud concerning cryptocurrencies. The IRS believes that greater resources need to be devoted to preventing tax fraud and crime, especially concerning cryptocurrency markets that are already characterized by lax or no regulation. Crimes such as money laundering, terrorism financing, wire fraud, cyber-attacks, and ransoms are increasing because of the pseudonymity of crypto transactions and lenient AML/KYC laws. In addition to preventing these crimes, the IRS is keen on investigating those who are falsely reporting their virtual currency income or those who are intentionally failing to report their income from virtual currency transactions.
Finding law firms, attorneys and tax professionals experienced in legal issues, tax reporting, and cryptocurrencies can be a very challenging task.
Not many law firms are experienced in dealing with cryptocurrencies and crypto trading, much less their tax reporting obligations. For this reason, crypto investors must do their own research and ask questions before they retain a law firm or CPA to handle their cryptocurrency-related issues. In addition to filing your taxes, a tax attorney, tax professional, or CPA can help you in other ways such as by giving you an overview of the IRS´s current treatment of cryptocurrency transactions. Other matters that a tax attorney can assist you with include developing a comprehensive compliance program or drafting detailed AML/KYC policies for your business. Further, an attorney experienced in cryptocurrency-related issues is not limited to helping you with tax and IRS subjects. They may also be able to advise you on legal issues under the federal securities laws, investment adviser regulations, FinCEN rules, and the Bank Secrecy Act.
“Many investors are eager to invest in cryptocurrency opportunities. At the same time, the investor is at a significant loss if they do not undertake proper due diligence or fully understand the nature of the crypto market, tax reporting obligations, or federal agency positions on cryptocurrencies. Hiring a law firm experienced in cryptocurrencies can reduce your liability exposure and boost your compliance efforts.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.
Cryptocurrency investors need to heed the above factors to fully understand the inherent nature of cryptocurrency investments and to enable investors to make informed decisions to protect their investments. By properly studying the history of IRS guidance, the triggers of tax reporting obligations, the tax reporting process itself, IRS and criminal proceedings, and tips for finding a law firm, crypto investors will be better prepared to manage their cryptocurrency investments.
Oberheiden P.C. © 2022 National Law Review, Volume XII, Number 59