The Crypto Resurgence -- Key Tax Issues
May 18, 2021
By Thomas Cardinale
As the pandemic slowed or shut down a wide swath of industries over the last 12 months, a great awakening occurred in the cryptocurrency world. Unlike the boom in late 2017 where the fast rise of digital asset prices appeared to be a FOMO (fear of missing out) craze among retail traders which only lasted a few months, experts are saying it is a different story this time around. New players are 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 mark.
Similar to the 2017 boom, the quick appreciation in crypto prices has resurrected the public’s interest in tax issues. Below we touch on some of the most common digital asset transactions and how they are usually treated under current U.S. tax law.
Tax Basics of Holding and Selling Crypto
The IRS treats digital assets as “property” and follows the existing tax regulations of the same. In addition, a comprehensive FAQ released last year by the IRS conveys the message that the tax treatment of selling digital assets is similar to that of selling stocks and equities. In other words, 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 home state tax impacts. As a potential tax planning benefit, 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 another crypto for it (such as bitcoin). A crypto-for-crypto transaction sheds light on the concept of a like-kind exchange, a popular tax-deferred mechanism. However, federal tax reform at the end of 2017 dramatically changed the like-kind exchange playfield. As of today, only business realty assets are left as qualified assets to engage in a like-kind exchange for tax purposes. Digital assets, like crypto tokens, are no longer qualified for a like-kind exchange for tax purposes effective January 1, 2018. When exchanging one crypto for another, you must now recognize a tax 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 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 (NFT). 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. Twitter founder Jack Dorsey made headlines by personally auctioning his very first tweet as an NFT digital file for nearly $2.9 million.
Since by nature an NFT would not have any tax basis, in the above example the entire $2.9 million gain would be taxable income to Mr. Dorsey, likely as a long-term capital gain on the sale of digital property (potentially at a higher 28% collectibles federal tax rate). He ultimately donated the proceeds in the form of bitcoin to charity, so he also could conceivably obtain a corresponding tax write-off.
As of today, the NFT world is mostly dominated by artists, popular figures, and the entertainment industry. However, considering someone would pay $69 million for an NFT collection of artwork from digital artist Beeple, other industries are taking notice and brainstorming a potential new revenue stream. The salivating taxman will be waiting somewhere in the background.
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 can just utilize a person’s home 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. Users can easily expect a 5-15% annual return on their crypto balance from staking -- certainly more lucrative than the returns of many investing vehicles.
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 (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.
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Considering that the IRS has ramped up enforcement efforts for underreporting of digital asset gains, participants need to be prudent with their tax situation and keep proper records. As with any dynamic area such as crypto assets and the blockchain, it is vital not to assume tax treatment of certain transactions and to get in touch with an expert.