Cryptic Territory – An Update on Digital Assets and Tax Implications

In recent years, cryptocurrencies and digital assets have seen a rise in activity and popularity among the general public. Accordingly, the IRS has increased its efforts to provide guidance on the tax treatment and reporting requirements for taxpayers involved in these activities.

Tax practitioners, as well as their clients, should be aware of these updates on digital assets and their tax implications. And they should also be aware of the requirements to adequately address questions on their tax returns inquiring about the participation in digital asset activity and subsequent disclosure.

Digital Assets Defined

According to the IRS, digital assets are defined as “any digital representation of value which is recorded on a cryptographically secured distributable ledger or any similar technology as specified by the Secretary.” The IRS provides examples of digital assets including cryptocurrency (virtual currency that can be used for payment), stablecoins (a type of cryptocurrency that is tied to another currency, commodity, or financial instrument), and NFTs (non-fungible tokens that are unique digital identifiers recorded in a blockchain).

Disclosure on Individual Tax Return 

Regardless of whether a taxpayer is involved with digital assets or not, every individual filer must answer the question on the front of Form 1040, U.S. Individual Income Tax Return, whether they received or sold a digital asset in the taxable year. New to 2022 forms, the question provides more detail and specifics to help preparers know when to check boxes “Yes” or “No” correctly. The instructions for the 1040 form are also referenced to provide additional clarity. The question reads as follows:

At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)? (See instructions.) ☐Yes  ☐No

In general, a taxpayer should check “Yes” if they received digital assets as a form of payment, reward, or award. Additionally, if digital assets were received from mining activities or resulting from a hard fork (splitting a cryptocurrency into two), a taxpayer should check “Yes.” If a taxpayer disposed of a digital asset via payment, sale, exchange, or trade for another digital asset or otherwise disposed of any other financial interest in a digital asset, a taxpayer should also check “Yes.” If a taxpayer simply held digital assets during the year and did not partake in any transactions, they can check “No.”  Transferring digital assets from one account to another with the same ownership, as well as purchasing digital assets using nondigital currency, should also result in a taxpayer checking “No.”

Reporting Digital Asset Income

Income derived from digital assets is reported similarly to other income, primarily depending on the source of the income. If digital assets are received as payment for employment, the value of those assets should be reported as wages on the tax return. If the digital assets received were payment for services provided, the value of those assets would be reported on Schedule C, Profit or Loss from Business. Likewise, if digital assets were otherwise disposed to customers as part of a trade or business, that activity would also be reported on Schedule C.

If digital assets are held as capital assets and sold, exchanged, or transferred, the activity is reported on Form 8949, Sales and Other Dispositions of Capital Assets, to calculate the gain or loss from that activity. The gain or loss is then reported on Schedule D, Capital Gains and Losses. If, however, digital assets were transferred to an individual other than the taxpayer’s spouse during 2022, Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, will generally need to be filed if the value exceeds $16,000.

Treatment of Significant Decline in Value of Digital Assets

The year 2022 saw a significant decline in the cryptocurrency market values, with the price of Bitcoin sharply falling and the collapse of the cryptocurrency exchange FTX. Expectedly, taxpayers filing 2022 tax returns who held digital assets may wonder what relief, if any, they have on their returns related to this decline. In January 2023, the IRS issued a memo advising that taxpayers who did not dispose of the digital asset and did not attempt to abandon it could not take a loss deduction. While some could argue that a cryptocurrency whose value dropped to a fraction of a penny is worthless, the IRS took the position that as long as the cryptocurrency was traded on at least one exchange, there existed the possibility that the value could increase in the future and was therefore not worthless for the purpose of a loss deduction.

Practitioners should note that the IRS memo is not an official ruling or position, and the IRS is not bound to the content contained within it and could be subject to change without notice. That said, practitioners and their clients should exercise caution in this realm, as digital assets are relatively new territory, especially regarding taxation. There are several unprecedented scenarios that taxpayers with digital assets may find themselves in, and consequently, there is a lot of uncertainty revolving around positions one could take in reporting transactions involving digital assets. Therefore, following guidance issued by the IRS would be a conservative approach.

Donating Digital Assets

When taxpayers are charitably inclined and donate digital assets to a qualified nonprofit organization, are they able to receive a charitable contribution deduction? The answer is yes, but an IRS memo released in January 2023 specifies that a taxpayer must submit a qualified appraisal of the digital asset to take the deduction for donations over $5,000. Notably, values reported by cryptocurrency exchanges may not be used by taxpayers in lieu of qualified appraisals to support the amount of the deduction.

Depending on the type of digital asset donated, appraising a digital asset may be more difficult than appraising traditional tangible assets. While cryptocurrencies are regularly traded, NFTs are more complex, as they are unique by nature. Perhaps in light of this, there are already movements in Congress to propose excepting digital assets from the appraisal requirement. Until such legislation is passed, taxpayers should plan on obtaining an appraisal before donating digital assets to claim the deduction.

Why Understanding Tax Implications of Digital Assets Matters

While digital assets are becoming mainstream, tax practitioners may be wondering why this is relevant, particularly if they are under the impression that none of their clients are participating in digital asset activity. As the overall population begins to gravitate more towards participating in digital asset activity, the likelihood of a practitioner’s client base holding digital assets increases. In response, the IRS is more likely to increase its efforts in identifying tax returns that are not in compliance with disclosure and reporting requirements accordingly. Therefore, it is important to follow up with clients and see if there are any changes in their behavior toward digital assets.

Another issue stems from more businesses engaging in digital asset activities, and customers of those businesses may be engaging in digital asset activity without actively knowing it. For example, Starbucks Coffee is rolling out a new rewards program called Starbucks Odyssey that utilizes blockchain technology and uses digital stamps that unlock rewards. The digital stamps under this program are NFTs, and could trigger a taxable event if earned, traded, or redeemed. While this information is disclosed in Starbucks Coffee’s Terms and Conditions for the program, it is possible (and somewhat likely) that not everyone will read the 15-page document, even though they are required to agree to the Terms before participating in the program.

Practitioners can add value to their clients by being aware and having some familiarity with digital assets and the reporting requirements and communicating that information to them. Educating clients will help increase awareness of potential taxable events that could impact them, as well as help them make more informed decisions on whether to engage in digital asset activity and what tax consequences they may face.

By Chris Korban, CPA
Tax Materials Specialist, U of I Tax School

Sources

https://www.irs.gov/businesses/small-businesses-self-employed/digital-assets

https://www.irs.gov/pub/irs-wd/202302011.pdf

https://www.irs.gov/pub/irs-wd/202302012.pdf

https://www.irs.gov/newsroom/irs-updates-to-question-on-digital-assets-taxpayers-should-continue-to-report-all-digital-asset-income

https://www.taxnotes.com/tax-notes-federal/cryptocurrency/coffee-nfts-and-noncompliance/2022/11/28/7fd0c