‘Hodlers’ Get a Break: IRS Updates Virtual Currency Transactions Guidance

‘Hodlers’ Get a Break: IRS Updates Virtual Currency Transactions Guidance

by Yu Ting Wang, Jeremy Nau
March 12, 2021

On March 2, the IRS released an update to their FAQ on virtual currency transactions. Most notably the update clarified Q5, which relates to when a taxpayer should answer “yes” to the question on the 2020 Form 1040 that asks, “at any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

The IRS clarified that a taxpayer who “purchased” virtual currency with fiat currency (e.g., U.S. dollars) and had no other transaction in the year is not required to answer yes to the question on the Form 1040.

However, a taxpayer would still be required to answer yes if they engaged in any of the following activities during the year:

  • The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or hard fork
    • Example: Alice received the UNI airdrop in 2020 because her wallet interreacted with the Uniswap protocol.
  • An exchange of virtual currency for goods or services
    • Example: Bob bought a Tesla with his bitcoin.
  • A sale of virtual currency
    • Example: Alice told her friends she had “diamond hands” but cracked and sold her bitcoins at $57K.
  • An exchange of virtual currency for other property, including for another virtual currency, and a disposition of a financial interest in virtual currency
    • Example: Bob started experimenting with trading bots, racking up many trades per day.
  • Earned virtual currency for work performed
    • Example: Alice produced a slick website and social media content for her favorite token project and received some of the project’s tokens as payment.

Traders and Farmers Are Still on the Hook

As of early March 2021, bitcoin had seen roughly a 600% rise in value in the preceding 12 months. While mere buying and holding of virtual currency is no longer considered a complexity for tax reporting purposes, there are emerging use cases in crypto that lay bare gray areas in IRS tax guidance. Specifically, these include the rise of decentralized finance (DeFi) and associated token swaps, provisioning to liquidity pools, lending, borrowing and farming.

If you’ve traded using a decentralized exchange protocol (DEX) or were farming your favorite food coin in 2020, you almost certainly have an obligation to the IRS. In many cases, the IRS considers these activities “an exchange of virtual currency,” “a sale,” or crypto “earnings.” Therefore, in most cases DeFi activities create taxable events.

Are You Ready for Your 2020 Tax Filing?

To get a sense of your own tax readiness, consider the following:

  1. Record keeping: Do you have a reliable system to keep track of your virtual currency? Relevant data includes the date you received your virtual currency, the value at the time of receipt, the date of sale and the sales price.
  2. Direct or indirect investment: Do you hold your virtual currency directly or do you invest in a fund or any similar structure that invests in virtual currency on your behalf?
  3. Overseas exchanges: Do you trade virtual currency using exchanges outside of the United States? If so, do you know the approximate value of the virtual currency in that overseas exchange and your obligation to report on foreign accounts?
  4. Decentralized finance: Did you participate in any DeFi activity during 2020, such as DEX trading or liquidity mining? If so, have you been tracking your farming rewards?
  5. Token awards: Have you been granted any virtual currency awards? Have you made 83(b) election for such awards or is the award eligible for an 83(b) election to be filed? What is the tax implication of the token award?
  6. Highly appreciated virtual currency: Do you currently own highly appreciated virtual currency? Do you know you can donate highly appreciated virtual currency to charity and receive tax benefits? Have you discussed with your tax advisor any possible planning opportunity on liquidation of the highly appreciated virtual currency?
  7. Staking activity: Have you staked your crypto on a proof-of-stake blockchain or delegated your proof of stake? Have you tracked the amount of a block reward and the market price of the crypto at the time of receipt?
  8. Ensuring 1099 reporting matches your filing: If you hold significant value of crypto on any U.S. centralized exchange, your 1099 report should match your tax filing. Discrepancies between your 1099 and your filing are an easy way to get caught in the IRS net.

With the “cryptocurrency question” moved to the first page of the 2020 Form 1040, along with a recent report from the Treasury Inspector General for Tax Administration that found the IRS is not doing a good job identifying taxpayers with virtual currency transactions, we expect the IRS will increase its scrutiny on crypto taxpayer compliance.

If you have any questions or need help understanding the technical details of virtual currency transactions to optimize your tax opportunities, reach out to our Digital Assets team.

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