The Unique Tax Characteristics of Cryptocurrency
The cryptocurrency market is booming, and new players are consistently entering the fray, such as financial institutions, hedge funds, and large corporations — including Tesla, which recently purchased $1.5 billion in bitcoin. As of the date of this article, the global market cap of bitcoin is hovering around the $1 trillion marks.
And with this boom, we are seeing an increased interest in cryptocurrency tax issues. Below we touch on some of the most common digital asset transactions and how they should be treated under current U.S. tax law.
Tax Basics of Holding and Selling Crypto
The IRS treats digital assets as property. Accordingly, the tax treatment of selling digital assets is similar to that of selling stocks and equities. So, the tax treatment based on holding periods would still apply; short-term gains would be taxed at ordinary income tax rates (up to 37%) and long-term gains would be taxed at capital gains rates (20% rate + 3.8% net investment income tax), plus relevant state income taxes. In addition, any losses from crypto sales can be used to offset non-crypto-related capital gains in a given tax year.
Exchanging Crypto for Another Crypto
Although there are thousands of cryptocurrencies circulating globally, only a handful can be acquired with regular currency. The vast majority can only be acquired by exchanging one crypto for another. However, effective January 1, 2018 when exchanging one crypto for another, you must now recognize a taxable gain or loss on the crypto you are exchanging. The tax basis in the new crypto you acquired is the FMV at the time of the exchange. Depending on the platform being used to trade crypto, the intricate detail of gains or losses from token-to-token exchanges may not be readily available to the investor, and therefore require careful recordkeeping and related accounting of basis layers.
Tax Treatment of Non-Fungible Tokens
With years of focus on bitcoin and the tokenization of the blockchain network, there has been an undercurrent involving a new digital transaction regime – non-fungible tokens (NFTs).
An NFT can be thought of as digital property (artwork, audio files, clips, etc.) that cannot be copied and is authenticated by the Ethereum blockchain network via a custom identifier (similar to an IP address). While it is hard to convince anyone that a GIF or JPEG file cannot be copied, a specific user address and its digitally audited transaction in acquiring an NFT cannot be.
Any sale of an NFT would be treated as a capital gain transaction, and if held for more than one year would be taxable as a long-term capital gain on the sale.
Taxation of “Staking” – A Rising Investment Opportunity
Another newer byproduct of the blockchain universe has been presented in the form of staking, which is short for the blockchain term Proof of Stake (PoS). In layman’s terms, the process of staking helps validate digital transactions that eventually get added to the blockchain. Staking can be considered a lighter version of the standard bitcoin mining operation which expends significant computing and energy resources. In the simplest case, staking would utilize a computer to help validate digital transaction blocks but is concurrently linked to a digital wallet containing a restricted crypto balance. The staking network would occasionally award the user with new crypto tokens generally measured by the balance committed to staking by the user.
For example, a user creates a new wallet with 32 Ether (Ethereum network token) and allocates the entire balance to staking (the user must first go through some acceptance and technical procedures beyond the scope of this article). After one year, the user’s digital wallet now has 35 Ether in it (having been awarded three from staking). The three new tokens are valued at $10,000. How would this reward be taxed? While there is no specific tax law covering this area, the most widely held belief is that the rewards would be a taxable substitute to interest income or ordinary income in the year deposited into the user’s wallet. Some users believe it would be taxable only upon the future sale of the awarded tokens, which is not correct. The eventual sale of the awarded tokens would be a separate taxable transaction for a gain or loss, to which the user’s cost basis is what was recognized as ordinary income when earned.
The IRS has ramped up enforcement efforts for underreporting of digital asset gains. Accordingly, participants need to be prudent with their tax situation and keep proper records. And be careful to choose the correct tax treatment of crypto-asset transactions.
The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.