In March 2021, the IRS announced the launch of Operation Hidden Treasure, a new enforcement initiative for tax violations related to cryptocurrency and digital assets. The operation is a partnership between two IRS divisions: the Office of Fraud Enforcement and the Criminal Investigation unit. We and other experts anticipate the number of inquiries and audits will rise significantly for taxpayers who have not properly reported cryptocurrency transactions.
While the IRS is ramping up enforcement, they have been asleep at the wheel in other respects, failing to provide taxpayers clear guidance on commonplace and complex crypto transactions. However, there are several key considerations to properly document compliance and reduce risk while optimizing your tax burden.
To help, we’ve compiled answers to the most common questions we hear on the topic.
Yes, even small or casual exposure to crypto in your personal portfolio requires a response on your tax form. (See the next question.)
The IRS revised this question from year 2020 by replacing the word “acquire” with “dispose of.” This provides more clarity — the IRS is asking taxpayers to report all activities with cryptocurrency. This includes using cryptocurrency to pay for services, because a service is a form of disposal.
It is crucial to have a reliable system to keep track of your investing and trading activities, whether software-based or simple notes. We recommend that clients keep a journal of all trades with the context of the transaction.
Additional documentation to keep as best practice (and documentation requested in cases of audit) includes: Records of any cash deposits or withdraws to/from centralized exchanges; the exchange accounts you have used to hold, transfer or trade crypto; all self-custody wallet addresses; and of course, a complete record of all trading, spending, lending, staking, wrapping or mining activity.
That complete record must include: the date of any crypto trade, NFT or other token purchase, cash deposit or withdraw, transfer between exchanges or to/from self-custody, or income even from staking or mining. In addition, each of the transactions noted above must include a cost basis or value for the transaction.
An airdrop is a bit like a retailer putting a gift card in every mailbox in town. You may not have asked for it, but it may have some market value and may be income at the time it is received. Whether or not to claim income for all airdrops requires more analysis and is an area where you should talk with your CPA.
Did you receive stablecoins or other crypto as a form of compensation for services you performed? If yes, you will need to consider whether the crypto you received (the US$ value) was included on a W-2 (paid as employee) or 1099 (paid as a contractor). If so, your reported income on your form 1040 should match. If not (let’s say you received income from a DAO project you worked on), this is still reportable income and should be reflected in your trade history and 1040.
If you are accustomed to trading stocks and receiving a 1099 from your broker for the dividends and gains in the tax year, you may be surprised by what you receive (or don’t) from your crypto exchange. While some exchanges are starting to produce such reporting documents, there is still a diversity of practice. You may receive a 1099-INT from one exchange and a 1099-B from another.
Whether you receive 1099s or not, and whether the exchange you used is onshore or not, you should plan to keep accurate records that will enable you to track all income, gains and/or losses from all transactions involving digital assets.
You must report sales of cryptocurrency on Schedule D, Form 8949, with either short-term or long-term capital gains or losses. If this is your second tax year with crypto on the books, you know that tracking cost basis is easier said than done. Whether you have minimal transactions or are a high-volume trader, comprehensive visibility of these key areas is vital. Tech-enabled tax services can aid in proper basis tracking and in tax compliance.
You must include the cryptocurrency you received as compensation for services performed on Form 1040 as ordinary income. Fair market value of the cryptocurrency at the time it is received is the income you must report. Depending on the nature of the services, self-employment income tax may apply.
You must first recognize the capital gain or loss for the cryptocurrency you used to pay for the services. Then, depending on the nature of the services you paid for, it may or may not be a deduction on your tax returns. If you have a trade or business and are using cryptocurrency to pay for services, once you recognize capital gain or loss on the usage of the cryptocurrency as a payment, you can also take an ordinary deduction on Schedule C or other relevant tax forms reporting the trade or business activities.
Mining of a cryptocurrency may be considered self-employment income if you are actively involved with mining activity and treat it as a trade or business activity. If this is the case, you can report mining income on Schedule C (assuming it’s a sole proprietorship). You can report ordinary and necessary business expenses associated with the mining activity on the same schedule. If you treat mining as an investment activity, your mining income is reported as other income that is not subject to self-employment tax. The business expense associated with the mining activity is not deductible. In both cases, fair market value of the cryptocurrency at the time it is mined is the income to report on your tax returns.
Despite the IRS’s decision from the recent case Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn.), it is advisable to take a conservative approach where staking income should be reported and included as ordinary income when the staking reward is received. Specifically, reportable income is the fair market value of the staking rewards at the time they are received. In some cases, this may require applying a valuation to your block reward data, marking income in reasonable timeframes such as daily. (If you want to learn more about mirroring the Jarrett approach, check out the Proof of Stake Alliance.)
Casual investing and/or playing to earn is creating novel tax questions for CPAs and regulators and big headaches for investors and gamers. While the treatment of non-fungible token trading is not clearly outlined by the IRS at this time, CPAs are applying analogies to the treatment of other cryptos, meaning that all the FAQs above apply.
For play-to-earn and other in-game NFTs, record-keeping can be especially important. Similarly, ensuring you have an investment management strategy is key. One example to be cautious of would be earning in-game tokens (income at time received) and holding them as they depreciate significantly, leaving you in a position where you have to pay income tax that is outsized compared to the current value of the earned assets.
This is an area that the IRS is focusing on more, and they are encouraging taxpayers to proactively get ahead of their tax situation rather than waiting to receive a notice. The IRS recently added an expanding section on reporting virtual currency on Form 14457, Voluntary Disclosure Practice Preclearance Request Application. This is an opportunity to correct mistakes or file delinquent returns related to virtual currency activities. Given the complicated nature of such proceedings, the IRS recommends you consult a trusted tax professional for guidance.
If you have additional questions on how to proceed with your tax filings, don’t hesitate to reach out to our digital asset tax experts.
