Cryptocurrency continues to garner popularity around the globe yet remains in headlines as countries grapple with how and whether to recognize it as legal tender. In September 2021, El Salvador adopted Bitcoin as official legal tender whereas China has banned cryptocurrency transactions altogether. Other countries are considering developing their own cryptocurrency, and in the United States, the IRS has developed some reporting requirements for tax purposes.
What is Cryptocurrency?
Cryptocurrency is a digital currency, backed by blockchain technology, which acts like cryptocurrency’s distributed ledger. Similar to how a bank operates with debits and credits, blockchain’s ledger records transactions. Cryptocurrencies are stored in digital wallets, indicating ownership, and can be sent to other wallets as a gift, or for payment of services of an item, all while being documented in the blockchain of each movement they take. There are thousands of types in existence, but a few of the most popularly used are Bitcoin, Ethereum, Litecoin, Cardano, Polkadot, USD Coin (USDC), to name a few.
Each cryptocurrency has a different purpose of use. For example, Ethereum is used to drive smart contracts; Cardano and Polkadot were designed to counteract chain interoperability and Stellar connects financial institutions for large transactions and allows for cross-border transactions. Another type of cryptocurrency, USDC, was created by Coinbase and is a U.S. dollar-backed currency.
Cryptocurrency is fungible, meaning it can be divided into smaller and smaller pieces. At the date of this presentation, Bitcoin is worth around $60,000 dollars which can then be divided into smaller denominations. One person likely isn’t buying one bitcoin at a time, but rather purchasing or trading fractional pieces.
What are NFTs?
NFT’s are non-fungible tokens that represent an object in the digital or physical world tracking ownership between an individual and a thing. NFTs are programmable and developers can change or enhance them, giving them boundaries like contracts baked into them.
Examples of uses for these tokens can be:
- Digital goods: Creators can tie NFTs to digital art. This allows digital art to be tied to an NFT asset. The infamous example of this is when artist Mike Winkelmann sold a digital work of art at an auction house for $69M through an NFT sale.
- Property: Physical products can be tied to NFTs as well but require licensing before the NFT creation itself. Royalties can be applied within the NFT upon creation.
- Identity: NFTs can be used to declare and verify identity for official purposes as well as transfer assets with a public, verifiable record.
NFTs are forever and last beyond the life of a company and royalties can be built into the tokens, so that revenue continues to be generated each time someone uses it. NFTs can be transferred between individuals, and there are contracts that allow NFTs to be sold through programmable smart contracts on secondary marketplaces, such as OpenSea.
Cryptocurrency Tax Treatment
As a result of its rising popularity and use, the IRS began asking taxpayers to document any virtual currency transactions on their 2020 individual income tax returns.
IRS Form 1040, the individual tax return, reads “At any time during 2020, did you receive sell, send exchange, or otherwise acquire any financial interest in any virtual currency?” As a point of clarification, you only had to check that box if you bought and sold different currencies, not if you only held cryptocurrency.
Currently, the IRS treats cryptocurrencies as property, not “real currency” or legal tender. It’s treated the same way as stocks, which means it’s subject to existing tax principles that apply to property transactions.
Do you have to report capital gains and losses on cryptocurrency?
Whenever you trade or sell cryptocurrency, you must report the capital gains (or losses) on it.
A capital gain or loss is recognized when cryptocurrency is sold, exchanged from one cryptocurrency to another, or used as payment for goods or services. If you exchanged one type of currency to another, say from Bitcoin to Ethereum, even though no cash was exchanged, the currency traded is treated as sold. This is a relatively misunderstood scenario and is treated as such: a gain or loss reported on the sale of the Bitcoin and separately for the purchase of Ethereum.
There are different holding periods for tax purposes on cryptocurrency. The holding period begins the day after acquisition and ends on the day sold or exchanged. If sold or traded within the year of purchase or receipt, it is taxed at the ordinary income rate. This is what is known as a short-term holding period.
For those currencies that are sold or traded outside of that one-year mark, or long-term holding period, they are taxed at a different rate, as high as 20 percent. If the pending tax legislation is passed, the tax rate could increase to a top rate of 25 percent in 2022.
Ordinary income
There are situations when a taxpayer would have to recognize cryptocurrencies as ordinary income, rather than as capital gains or losses, i.e. when it’s treated as inventory, or held for sale. The taxpayer recognizes the fair market value of the virtual currency on the date of receipt. If a taxpayer does not treat virtual currency as a capital asset, gain or loss is considered ordinary, not capital.
Reporting Requirements
A variety of reporting requirement caveats exist for differing scenarios, depending on the taxpayer’s income sources. More companies are beginning to pay employees with cryptocurrency. In this scenario, the taxpayer would still report their wages as regular income on their W-2. For independent contractors, cryptocurrency would be reported on the 1099 form if received as payment.
Non-Taxable Events
There are many non-taxable events that would not trigger a reporting requirement on your tax returns. Some of those are:
- Virtual currency gifts received – When you receive cryptocurrency as a gift, it’s just as if you received property as a gift, as long as you stay within the regular gifting threshold amounts allowed.
- Soft forks – When there is a change in the protocols within the blockchain technology and is initiated by developers and would occur if there is a major hack, for example.
- Charitable contributions – Donating cryptocurrency does not trigger capital gains or losses.
- Transfer currency between wallets or accounts – Transferring cryptocurrency between accounts or wallets is not considered a taxable event. This would be treated as transferring cash between bank accounts.
For questions related to tax considerations and reporting requirements related to cryptocurrency, contact Matt Nguyen, or your Windham Brannon advisor.
NFTs and Cryptocurrencies- An Overview and Tax Considerations
