The Bitcoin blockchain went live over thirteen years ago on January 3, 2009. If you’re like most investors, you may have considered investing in the cryptocurrency asset class, or if you are more adventurous, non-fungible tokens. As with all investments, the tax man wants his “fair” share.
Over the past 13 years, the IRS has delivered very little guidance on how cryptocurrency transactions should be taxed. The IRS released Q&As in Notice 2014-21 with the main takeaway that a cryptocurrency is property (and therefore not a foreign currency) that is subject to the general tax principles governing property. Later, the IRS followed up with Revenue Ruling 2019-24, which addressed airdrops and a hard fork in a blockchain (see also CCA 202114020). You may have noticed that the IRS started asking about your cryptocurrency transactions beginning with the 2019 tax year Form 1040. The questions subsequently have been modified and made more prominent on the Form 1040.
Why does the IRS specifically ask about your cryptocurrency transactions? They believe many investors in cryptocurrency are not paying their fair share. I assume there are some investors that may have intentionally failed to report gains from cryptocurrency, especially when those transactions previously have not been subject to information reporting. Furthermore, I assume there are investors that have engaged in cryptocurrency transactions without realizing the transactions were subject to taxation. However, that old maxim applies – ignorantia juris non excusat – ignorance of the law excuses not.
The most common example of this is exchanging one cryptocurrency for another, say Bitcoin for Ether. Suppose an investor purchased one Bitcoin many years ago for $1,000 and it is now trading at $41,000. The investor decides to trade out of Bitcoin and uses that one Bitcoin to purchase $41,000 of Ether. Guess what? The investor realized a long-term capital gain of $40,000 on the built-in gain associated with that one Bitcoin. Assuming a 20% long-term capital gains rate, the tax man’s fair share is $8,000. Some investors may find this hard to believe because they think they haven’t cashed out, in other words they haven’t put greenbacks into their pockets. However, the same rule applies if an investor exchanges IBM shares for Apple shares – it is a realization event. Likewise, someone using a cryptocurrency to pay for services would have to realize any built-in gain or loss at the time of payment.
The real fun is about to begin in 2023 with respect to information reporting. In the Infrastructure Bill signed by President Biden in November 2021, there are provisions that require form 1099-B reporting (the form you receive from your broker identifying the past year’s trades in securities) by companies that effectuate transfers of digital assets and form 8300 reporting by a business, if a customer has digital asset transactions in excess of $10,000, thus treating cryptocurrency as cash for this reporting purpose. These new tax rules take effect January 1, 2023 with the reporting requirements starting January 1, 2024. Some players in the crypto industry believe that the definition of “broker” for this purpose is drafted too broadly and should be scaled back. Only time will tell.
The IRS is not the only agency in the alphabet soup interested in cryptocurrencies. The SEC has brought enforcement actions in connection with cryptocurrencies under the belief that a cryptocurrency is a security. The CFTC has also asserted its jurisdiction in this space. And the Federal Reserve is starting to poke around, especially with respect to stablecoins. The question that the IRS has yet to answer is whether cryptocurrencies and contracts with respect to cryptocurrencies are securities and financial instruments. Some other agencies think so. Therefore, do the tax rules governing, for example, securities lending, wash sales, section 1256 contracts, etc., apply? Once again, only time will tell. One thing is for certain, the sheriffs are starting to multiply in the formerly wild west of digital assets.