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The Basics of Cryptocurrency and Taxes

Cryptocurrency is becoming more mainstream, but the associated tax implications can be confusing.

With no generally accepted accounting practices (GAAP) standards on the books or under consideration in the United States, current accounting guidelines for digital assets creates reporting complications for those who buy, sell, lend and/or invest in the cryptocurrency market.

These complications and limited accounting guidance leave those involved at risk for audits and regulatory scrutiny or questions from investors and analysts.

What is cryptocurrency?

Cryptocurrency is a digital or virtual currency secured by cryptography, often from decentralized networks based on blockchain technology and generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.

However, according to the IRS, virtual currency is treated as property and general tax principles applicable to property transactions also pertain to transactions using virtual currency.

For many companies, they classify their crypto holdings as indefinite-lived intangible assets as opposed to inventory assets, which have different accounting guidelines.

How does it work?

Using crypto to purchase anything is deemed to be a sale of that crypto for cash, and then that cash is in turn used to purchase items, meaning you will have a gain/loss of the crypto when you purchase the item, and then a gain/loss once again when you sell whatever you purchase.

This is particularly important when dealing with non-fungible tokens (NFTs) as that is a common way to acquire NFTs.

What are the tax implications?

The IRS is extremely focused on cryptocurrency, and it is important to be transparent about your crypto activity regardless of the size or purpose of the transaction.

On the face of Form 1040, the IRS asks, “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” This applies to those who sold or spent their cryptocurrency, those who exchanged one cryptocurrency for another, and those who engaged in other taxable events — such as earning interest on cryptocurrency — in 2021.

Anyone who simply bought and held cryptocurrency won’t be liable yet.

NFTs are likely included in this question, although it is not specifically mentioned.

Since it is viewed as property and not a security, there are currently no wash sale rules for crypto that prevent taxpayers from selling a security at a loss and immediately buying that same stock back, unlike stocks.

However, this current loophole for crypto investors is scheduled to end if the “Build Back Better Act” is passed by the Senate and signed into law. But as of February 2022, the bill is in limbo despite the U.S. House of Representatives passing it on Nov. 19, 2021.

It is also important to note that when you donate crypto to a charity, you are not treated as if you are selling it first. Instead, you receive a deduction for the fair market value of the currency at the time of donation, so it is a good planning item for highly appreciated coins.

What can you do now?

Good recordkeeping is one of the most vital actions you can take while dealing with cryptocurrency, especially if you have multiple active wallets or accounts.

The IRS requires taxpayers to maintain sufficient documentation, including records of receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency.

If you have any questions about the information above, please contact your E. Cohen advisor.