Digital Assets Fireside Chat: Year-End Tax Considerations
December 06, 2022
If you invest in cryptocurrencies, NFTs or other digital assets, you most likely experienced volatility and turmoil this past year. Even with prices falling, liquidity drying up and crypto companies filing for bankruptcy, investors may find tax planning opportunities in this current market. Regardless, we understand this level of volatility may create more year-end stress as you start thinking about tax planning and reporting. This digital assets fireside chat with EisnerAmper’s tax partner, Nate Shubert, and blockchain and digital assets manager, Walter Zinenko, will cover some of the main year-end tax issues that you should plan for and discuss with your tax advisor.
Walter Zinenko:Definitely. And before we start, I think we should address the elephant in the room. Obviously, FTX is going through bankruptcy. There is a lot of uncertainty in the market. Funds are involved. Individuals have funds locked in FTX and don't know when they'll ever get those back. So, maybe we can start with some questions that you've been fielding for our clients.
Nate Shubert:Yeah, it's obviously a tough situation for a lot of people. First question they're asking is, "What do we do? We have these funds that are locked in FTX, can we take a loss on them? What's the remedy?" In order to have a loss, you have to realize a transaction. And unfortunately, they're not able to sell those assets to create that realized loss. Next you look at are we expecting anything? The fact that it's in bankruptcy right now, there is a presumed expectation that hopefully they get something. It really puts people in a tough situation. So, again, it's one of those things that really needs to be discussed with your advisor of what you can do. Looking at a different side is from a start-up perspective. There are start-ups that receive funding from, say, FTX Ventures or Alameda Research, and what's going to happen with that funding and are there any implications there.
Walter Zinenko:I wish we could say this is the only failure in the crypto industry related to centralized exchanges, but it's definitely not. This is an ever-evolving situation. It's been happening for the last few months. Anything else to add before we jump into questions?
Nate Shubert:Yeah, I think you're referring to Voyager and Celsius there. With that, I think it's a good reminder for everyone, “Not your keys, not your coins.” There's now a perception that if you are keeping your assets on exchanges, this inherent risk is out there. It's not like a normal bank account with the FDIC insurance, for example. When you’re discussing this with your tax advisor, make sure you're looking at what basis you have. You're not able to take a loss for what the value is because you haven't necessarily paid taxes on all that. There is a lot that goes into this planning.
Thanks. And on a personal note, does this impact your perspective on crypto, on digital assets in general?
Well, yeah, it doesn't help the space, right? It creates negative press. It reminds people that what's important is you should probably have those keys to those assets. And it's probably going to pave the way for some regulation, and I think a lot of people are actually looking for some regulation in this space. That goes on the tax side as well.
Walter Zinenko:Yep. From my perspective, I think Satoshi created Bitcoin because he didn't trust an intermediary. I think that's what we've seen in the marketplace in the last few months is these centralized exchanges failing for one reason or another. On the topic of losses, is there anything else that our clients or customers should be considering heading into year end?
Yeah, I think they should be looking at their overall tax picture. If they have any net capital gains, they should definitely be considering if they should harvest any losses. If there's any specific assets that they have, not just in crypto actually, anything, should they sell those assets to generate or realize that loss to offset those gains? Something that's interesting is with stocks. You have the concern with wash sale rules, which is when you purchase a stock within 30 days after selling it for a loss, the IRS does not allow you to take that loss. That law is under the definition of securities, and the IRS has deemed crypto or cryptocurrency as property. So, there might be an opportunity here for taxpayers to realize some losses, reduce their taxable income this year, and if they like that asset, they can buy that again.
Walter Zinenko:Sure. And I'd like to highlight the fact that you said net capital gains. Because those losses are limited, correct?
Walter Zinenko:Yeah. A net loss of $3,000 a year is the amount you can deduct on a return. If you go beyond that net loss of three grand, it does carry over to future years for future tax benefits. And that's for an individual, right?
Got it. You spoke about crypto being property. Can we go through some other transactions specific to crypto and property transactions that would have a taxable effect?
Sure. This space has created a lot of new words or definitions for different types of activities. One of those is airdrops, and that's receiving an asset. Generally, you might have to go and claim that asset—pay gas, for example, on Ethereum—and that asset becomes yours if there is an ascension of wealth, which is what they look at. If you have a value to something, generally that will be a taxable event. Something else we need to look at is constructive receipt, meaning were you actually able to claim that asset? Were you able to sell that asset? We're talking about these things with our clients, looking at very specific transactions to determine whether there was a taxable event or not.
And you said new terms, but I think some of these activities are the same financial activity just wrapped up into a new term. I will say one that's definitely new, at least to me in the financial world, would be a hard fork. Maybe we can talk a little bit about that.
Nate Shubert:Yeah. When the Ethereum merge happened, there could have been new hard forks, new assets created. If you are receiving those assets, again, it goes down to constructive receipt and did you have an ascension of wealth. If so, it's probably a taxable event in those situations. Also just thinking of the web 2.0 world interest and then the web 3.0 world is staking, kind of thinking about the same thing as you're gaining value to something for providing that asset to someone else. And same thing, are you able to receive that asset? Something interesting with Ethereum right now is that you actually can't pull those assets out, so the question is then do you have constructive receipt? It's definitely something, if you're doing that, if you're staking Ethereum and other assets as well. Talk about that with your tax advisor.
Walter Zinenko:Other things that are still floating in the regulatory gray area would be liquidity pools, flash loans. Again, just important points that if you are doing those sorts of things, it's important to talk through how those are taxed or recognized from a tax perspective.
Nate Shubert:Yeah, good points.
Walter Zinenko:And one thing we've seen over and over again is that our clients are really having trouble keeping track of their lots, especially due to volume or complexity of transactions. Any thoughts there, Nate?
Nate Shubert:Yeah, you hit it on the head. It's tedious, lots of transactions to track, all at different prices. It's a lot to do. Generally, we recommend probably looking at a few software platforms to help with that. But the software only gathers the data. From that, we look at which method we'd like to choose for using that basis in the year. There are different methods you're allowed to use. We want to be as tax efficient as possible, and it's beyond your crypto activity. We want to know your overall tax situation to help us select which basis makes sense, which method makes sense.
Walter Zinenko:Yeah, there's a lot to unpack there. Keeping track, good books and records, it's almost like triple entry bookkeeping so you're not only keeping track of how much ETH you spend, but when you sent out that ETH, what was your gain or loss? What was the age—was it short-term, long-term? And what was the nature of the transaction so you can record it correctly for tax and possibly for GAAP if you're a company? With that, another complex area that doesn't seem complex on the surface but can get very difficult jumping in is NFTs. Let's just dive right in.
Nate Shubert:Yeah, it's definitely a buzzword. Back in March 2021 Beeple sold an NFT for $69 million. There are different parties involved with NFTs, so let me start there. There's the Minter, there might be the exchange that is helping facilitate a transaction, and a buyer or a seller of the NFT. The Minter is going to be a creator and will have some costs associated with creating that asset, that NFT. There could be just gas fees but could be some other types of costs as well. When they sell that NFT, it's probably ordinary income. They're generating that asset and selling it, so that's what they're going to have—the income at the time of sale, when the value is received. Let’s say they hold on to the ETH from their mint proceeds on a project, and then ETH drops in value. The IRS doesn't care that you sold ETH at $1,000 when the mint happened at $1,500. It's important to look at that situation. Not financial advice, but you may want to talk to your advisor about these scenarios and convert some to help cover your tax obligation.
Walter Zinenko:Definitely, because those transactions don't always offset. You may have a capital transaction with an ordinary income transaction, and that disparity could leave you and your bank account very unhappy.
Nate Shubert:Yeah, it's two different buckets. As we alluded to earlier, the limit on capital loss in a given year is only $3,000. A $100,000 capital loss is not going to offset $100,000 of ordinary income.
Walter Zinenko:Yep. Another aspect of NFTs is secondary sales and royalties. That's sort of in the same vein of ordinary income, right?
Nate Shubert:Right, at the time of receipt. So again, goes back to that tedious tracking of the volumes of activity there.
Walter Zinenko:Sure. And that's for creators, right? What are the other parties involved?
Nate Shubert:Yeah, let's move to the purchaser and the sellers. When you buy an NFT, that is a taxable event because you're using some form of crypto, and it's being converted to something else. There's no like-kind exchange for these assets, so there is a taxable event that occurs. Then you have to look at what are you buying? And who are you? Are you a business buying the NFT because it offers a subscription service? Are you an individual buying the NFT because you like the picture, holding it for artwork? There are many different forms of NFTs. Some have some utility. Others are an image or have rights to something.
Walter Zinenko:Then we get into is it a collectible, right?
Nate Shubert:Correct. There is a different tax rate for collectibles, 28% flat rate. There are lots of things to discuss with your advisor on that because every NFT is different. ERC-721s are all different, and many different projects are out there.
Walter Zinenko:And then lastly, to transact in NFTs, usually you need to use some kind of exchange. What's their role and what are their tax implications?
Nate Shubert:Yeah, great question. The exchange is going to hold that asset as its custodian. They don't own the asset, but they're helping facilitate that transaction with the smart contracts. They generally take a fee for doing that, just like the creator generally has royalty fees for receiving that. From the exchange's perspective, they're generating income on volume. They want those transactions—those sales—that's how they generate income, just like trader business activity.
Walter Zinenko:We’re talking about all of this to explain that these are the tax implications, right? If an exchange or a company is transacting here, the GAAP financial statement basis could be wildly different. I know you touched on subscriptions. Is it point in time versus over time, and the list goes on and on over recognition of revenue or different obligations there. We won't dig into it now, but it gets complex.
Nate Shubert:Yeah, taking a step back, tax versus GAAP is one thing, but there's very little regulation. We have a couple things from the IRS over many years that crypto has been around. And NFTs obviously haven't been around as long. Some regulation which might stem from recent events might come out, so it feels like every day is a little different in trying to catch up with what could be happening and to help advise our clients accordingly.
Walter Zinenko:Sure, can we just zoom out for a second to international tax and what those implications might be?
Nate Shubert:Yeah. The IRS looked more at international tax about a decade ago, and they really want to know what your overall tax situation looks like. You have to report taxable income based on your worldwide income. They want to know if you have any foreign bank accounts or foreign financial assets, foreign financial accounts, or if you're investing a certain dollar amount into foreign companies. Maybe you have assets on a foreign exchange that you put there a while ago, and you probably need to talk with your advisor about whether or not that should be reported as a foreign bank account. Also, if you have investments in foreign companies or start-ups, you might have to report those items. Failure to report is costly. It's a minimum $10,000 penalty for each form that was failed to be filed per year, so it can add up quickly.
Walter Zinenko:I think a central theme is something we haven't said yet, but it's been implicit in everything we've said—there's a lot of risk here. Along with international, there are OFAC sanctions, and just interacting with protocols or individuals that might be sanctioned, those penalties can wildly outweigh the civil penalties, right?
Nate Shubert:Correct. Yeah.
Walter Zinenko:Well, Nate, awesome conversation. Look forward to doing it again. And everyone else on the call, look forward to your comments.
Transcribed by Rev.com