Rise of Cryptocurrency Means Careful Tax Planning Needed

The phenomenon of cryptocurrency has gained steam over the past few years. The flexibility of this digital, encrypted, and decentralized form of exchange intrigues many, but it is causing consternation on how exactly to tax its use and how to mitigate some of the tax burden derived from its holdings.  

Often, individuals invest in cryptocurrency as they would stocks or other valuable assets, but cryptocurrency can be used to buy goods and pay for services too. However, it is not regulated or valued by a central authority like other forms of exchange, such as the U.S. dollar, euro, yen, or franc.¹  

When part of an investment portfolio that might also include stocks, bonds, and other tradable assets, investors purchase tokens. While this type of investment may be attractive to some, it can be a very risky investment because the market value for cryptocurrency is volatile.  

Cryptocurrency incorporates cryptographic proof of verified and recorded transactions that are added to a blockchain ledger, which is an open archive that records transactions in code that are irreversible and in chronological order.² Transactions are verified through computer programs as they are added to the blockchain. 

Because of the uniqueness of cryptocurrency, its tax treatment isn’t uniform. It all depends on its purpose.    

Cryptocurrency and the IRS

Cryptocurrency used as a form of payment for goods or services, bonuses for referrals, regular compensation for services, or as earnings from cryptocurrency mining is considered by the IRS as ordinary income and taxed at an individual’s applicable tax rate. 

In other instances, the IRS considers cryptocurrency as a form of property, similar to real estate or stocks. This treatment subjects cryptocurrency transactions to capital gains as well as ordinary income tax. These taxes are triggered when cryptocurrency is disposed of or when you earn income in the form of additional cryptocurrency. 

Capital gains taxes would be triggered when cryptocurrency is sold, used to purchase goods and services, or traded for another cryptocurrency. Any appreciation that had taken place related to these tokens would need to be reported to the IRS and taxed at applicable capital gains tax rates. 

Tax Form 1040 currently asks all taxpayers to declare if, during the year, they received, sold, exchanged, or disposed of a financial interest in any virtual currency. Taxpayers must answer yes or no, regardless of whether or not they engaged in any virtual currency transaction. According to the tax form’s instructions, taxpayers should answer yes if they engaged in activities such as receiving virtual currency as payment for goods or services; receiving or transferring virtual currency for free (not including gifts); receiving new virtual currency from mining activities; exchanging virtual currency for property, goods, or services; exchanging or trading of virtual currency for another virtual currency; or selling virtual currency. Taxpayers may answer no if the taxpayer simply held virtual currency in his or her own virtual wallet, transferred virtual currency between wallets or accounts the taxpayer owns or controls, or purchased virtual currency using real currency or real currency electronic platforms (i.e., PayPal or Venmo).³ These transactions do not meet the IRS’s definition of a taxable event. 

While the IRS may gain information regarding taxpayer cryptocurrency activities from Form 1040, there are other ways the IRS is tracking cryptocurrency activity. New guidance related to cryptocurrency was approved in the $1.2 trillion federal infrastructure legislation. The law requires brokers – “cryptocurrency exchanges” – to issue a 1099-B for cryptocurrency transactions.⁴ The goal is to prevent taxpayers from potentially hiding cryptocurrency gains. While 1099-B reporting may provide more transparency into cryptocurrency transactions, it may create tax reporting challenges for many. For investors who have historically been using their own cryptocurrency wallet, the information reported to the IRS on the 1099-B will have inaccuracies because the cryptocurrency exchanges reporting on trading activity will have a limited view into what these investors originally paid for their tokens. In addition, it is difficult for the IRS to define “brokers” of cryptocurrency. Section 6045(c)(1)(D) defines a broker as “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.”⁵ There are miners, stakers, and wallet providers who are an integral part of cryptocurrency transactions. If they are considered brokers, they would need to provide cost basis data to taxpayers.  

The decentralized world of cryptocurrency makes all of this very tricky. Because it is a peer-to-peer network rather than a centralized network, miners and stakers do not know who is on the other end of transactions, nor do they have the details of gross proceeds or cost basis of the digital assets being transferred. 

Despite the issues with reporting of information, it is still important to report taxable events accurately to avoid penalties or IRS audits. Investors should focus on keeping track of the cost basis of their cryptocurrency and to reconcile this with what might be reported on future 1099-Bs. Cryptocurrency was previously considered taxable property by the IRS prior to the new legislation; the additional reporting requirements raise the importance for investors to ensure they are reporting all their cryptocurrency activity accurately. 

Current Cryptocurrency Tax Strategies  

Cryptocurrency is risky, though some have gained substantial financial growth from cryptocurrency investments. Investors in cryptocurrency must understand some of the strategies available to help minimize tax payments. 

Harvesting losses – One of the most beneficial tax strategies associated with cryptocurrency relates to harvesting capital losses. Stocks are subject to a “wash sale rule,” but cryptocurrency is not.⁶ Under the wash sale rule, an investor cannot claim capital losses related to stocks if the investor purchased the same stock either 30 days prior to or after the sale. Capital losses related to cryptocurrency are not currently included in this rule. For now, investors can sell their tokens at a loss, claim this loss to offset any capital gains on their tax return, and then buy back their cryptocurrency immediately. This resets the investor’s basis in the cryptocurrency and can be done again if values continue to drop. Remember: capital gains can only be offset with the same type of losses. For example, short-term losses can be used only to offset short-term gains, and long-term losses may only be used to reduce long-term capital gains. ⁷ 

Long-term property – Another tax strategy that presents itself is to hold cryptocurrency for more than 12 months so the asset is classified as long-term property. Long-term capital gains tax rates are 0%, 15%, or 20%, depending upon the taxpayer’s filing status and taxable income. This is typically lower than the taxpayer’s ordinary income tax rate and would provide additional tax savings opportunities. 

Gifting – Individuals who are focused on transitioning wealth to their children, grandchildren, or others might consider gifting cryptocurrency. A cryptocurrency gift is not taxable to the individual making the gift or the recipient of the gift at the time the gift is made. A standard gift tax return may be required if the market value of the tokens is greater than $15,000.⁸ One important point: the person receiving the tokens needs to document the donor’s basis in the cryptocurrency to determine the tax owed when it is eventually sold. Assuming that the person making the gift is in a higher tax bracket than the person receiving the gift, the total tax paid on the disposal would be reduced. 

Charitable donations – Similar to the gifting strategy, individuals may want to consider making cryptocurrency donations. The taxpayer can record the donation at the market value of the tokens at the time of donation, and if the tokens had been held for at least 12 months, this amount can be deducted as a charitable contribution on the taxpayer’s tax return. This strategy provides a way for an individual to both achieve philanthropic support of a charitable organization and avoid potential tax on the appreciation of the cryptocurrency. Any appreciation on the asset at the time of the donation can be used to reduce an individual’s taxable income.⁹ 

Location – There are certain states – including Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Washington – that currently have no income taxes.¹⁰ For investors with significant appreciation related to their cryptocurrency holdings, relocating to one of these states could provide significant state tax savings when disposing of their tokens. Some countries, including Portugal and El Salvador, have announced that income received on cryptocurrency disposals are not taxable.¹¹ Puerto Rico has a unique tax benefit, in that taxpayers can exclude 100% of their capital gains from U.S. federal income tax. 

Strategic disposal – Choosing to dispose of cryptocurrency in a low-income year for the taxpayer can also be a potential tax savings strategy. Individuals nearing retirement may choose to wait until the tax year following their retirement when they are no longer collecting wages. This reduction in income may allow the taxpayer to qualify for a lower tax bracket, so capital gains from the sale of tokens would have a reduced capital gains tax rate as well.   

Self-directed IRAs and other retirement plans – Another strategy is to purchase cryptocurrency in a self-directed IRA. Most IRAs allow the investor to purchase standard investments, such as stocks, bonds, mutual funds, or exchange-traded funds. A self-directed IRA allows investments in other assets, including real estate, precious metals, and cryptocurrency. The tax benefits will vary depending upon the type of IRA that is established (Roth vs. traditional) and the individual’s tax situation. 

Defined contribution plans have begun to allow participants to invest in cryptocurrency, too. The technology-based 401(k) specialist ForUsAll Inc. announced in 2021 that plan sponsors would have the ability to adopt an investment platform that allows participants to invest up to 5% of their retirement account balances as well as 5% of contributions in cryptocurrency.12 This was a revolutionary change and began to open opportunities for retirement savers to begin investing in cryptocurrency. In early 2022, Fidelity announced that it would allow participants in their plans to invest up to 20% of their account balances in Bitcoin if plan sponsors approved the revised option. Investing in cryptocurrency through a retirement account allows participation in the cryptocurrency marketplace while deferring any potential significant gains until funds are withdrawn in retirement.  

HIFO method – Detailed record keeping related to the purchase and cost basis of cryptocurrency is critical for tax reporting. One way this recordkeeping can be beneficial is through the “HIFO” (highest in, first out) accounting method to calculate capital gains and losses. Using the HIFO method, an investor disposes of the cryptocurrency with the highest cost basis first to reduce the amount of capital gains that could be taxed.¹³ An example of this methodology would be if an investor purchased two separate tokens in 2019: one having a cost basis of $5,000 and the other having a basis of $8,000. If the investor sells one token for $25,000 in 2022, the HIFO method establishes the cost basis of the share at $8,000, reducing the potential taxable capital gain amount by $3,000. 

Conclusion

Based upon the tax reporting challenges, any successful tax strategy will rely on maintaining timely and accurate documentation to support financial activity used to prepare tax returns. Cryptocurrency tax software is available in the marketplace and is one way to track and document cryptocurrency transactions. These tools integrate activity from the various exchanges into many tax software packages. They can also be beneficial in providing a detailed transaction trail for accounting and tax preparation. 

Cryptocurrency is an evolving marketplace. Those engaging in cryptocurrency transactions face very high risks on the potential for returns. It is important for individuals to understand all the risks, especially the evolving tax reporting scrutiny that these types of investments carry. As cryptocurrency has developed into a “new frontier” for investors, IRS tax regulations will continue to expand and be refined to address these transactions.  

Investors in cryptocurrency who are trying to navigate recent revisions to tax laws should strongly consider partnering with a tax advisory firm that specializes in these types of transactions. While there has been recent conversation and consideration to delaying some of the tax reporting provisions, investors should consider obtaining the appropriate documentation to comply with impending reporting requirements.   

¹ Kate Ashford, “What is Cryptocurrency?,” Forbes Advisor (2022). 

² Jiajing Wu, Jieli Liu, Yijing Zhao, and Zibin Zheng, “Analysis of Cryptocurrency Transactions from a Network Perspective: An Overview,” Journal of Network and Computer Applications, (190, 103139, 2021).   

³ Paul Bonner, “Individual Taxpayers Must Answer Cryptoasset Question, IRS Notes,” Journal of Accountancy (March 22, 2022).  

⁴ John Puterbaugh, “Two Things Crypto Investors Should Know about the Infrastructure Bill President Biden Signed,” NextAdvisor (May 3, 2022).   

⁵ Pete Ritter, Joshua Thompkins, and Hubert Raglan, “Early Signs from Treasury on the Scope of Digital Asset Cost Basis Reporting,” The Tax Adviser (June 1, 2022).   

⁶ Sonia Dumas, “Help Your Clients Keep More Money: 5 Crypto Tax Strategies,” Intuit Tax Pro Center (Jan. 19, 2022).   

⁷ Taylor Locke, “3 Ways ‘Savvy’ Crypto Investors Can ‘Actively Use the Tax Code’ to Their Advantage, According to a CPA,” CNBC Make It newsletter (Feb. 1, 2022).  

⁸ Miles Brooks, “10 Simple Strategies to Reduce Your Crypto Tax Bill,” Coin Ledger blog. 

⁹ Riley Adams, “9 Ways to Cut Crypto Taxes Down to the Bone,” Kiplinger (July 25, 2022).   

¹⁰ John Waggoner, “12 States that Won’t Tax Your Retirement Distributions,” AARP (March 30, 2022).  

¹¹ Roger Huang, “Seven Countries Where Cryptocurrency Investments Are Not Taxed," Forbes (June 24, 2019).   

¹² John J. Topoleski and Elizabeth A. Myers, “Cryptocurrency in 401(k) Retirement Plans,” Congressional Research Service (Version 2, July 1, 2022).  

¹³ Miles Brooks, “FIFO, LIFO, and HIFO – What’s the Best Method for Crypto?,” Coin Ledger blog.