Crypto Losses

2022 was a rough year for cryptocurrency. Our investments tanked, obviously, but there was a lot of shady dealing as well. Rug pulls, pump-and-dumps, bankrupt exchanges, we saw it all. The question of when and how we can take deductions on a tax return is not an easy one to answer.

In the good old days before the Tax Cuts and Jobs Act, we'd have happily reported thefts and similar losses on Schedule A as an itemized deduction. Unfortunately for all of us, that option is gone until 2026.

But this doesn't mean we're out of options! Depending on the situation, there's the possibility that a particular fact pattern would allow the taxpayer to deduct a loss as a bad debt, or possibly the abandonment of an investment. Some circumstances might even allow for a Ponzi-type deduction. Every fact pattern will be different, so these decisions must be made on a case-by-case basis.

What are digital assets?

The IRS has bandied a lot of terms around. It was virtual currency, cryptocurrency, and now digital assets. It's a confusing space and nowhere is it as confusing as when it's time to file your tax return!

The IRS has issued only minimal guidance on digital assets so far. We had Revenue Ruling 2014-21, way back in 2014, when the IRS broke our hearts by declaring that cryptocurrency would be taxed as property.

In 2017, we learned that like-kind exchange wouldn't be an option starting in 2018.

In 2019, the IRS (finally) issued Revenue Ruling 2019-24, which dealt with one topic and one topic only: the taxation of forks and airdrops. We also got the online FAQs, which told us that the inventory options available were specific ID and FIFO, with FIFO being the default option. We also learned that the donation of cryptocurrencies would be treated as the donation of appreciated assets.

We've had a few Chief Counsel Memos, none of which really added anything to our understanding of crypto taxation.

Tax Rules!

Here's a quick summary of the crypto rules and regs so far. Mind you, this is a summary! There are a lot of nuances involved, especially when we try to apply these rules to other digital assets such as NFTs.

1. Virtual currency is treated as property by the IRS. This is the single most important principle; all else follows from this.
2. Virtual currency is not foreign currency, so no foreign currency exclusion exists. Yes, El Salvador had made Bitcoin fiat currency, but the IRS has not removed that restriction.
3. Virtual currency is self-employment income when received for services, valued at its fair market value as of the date and time of receipt. This means that this income, net of expenses, is subject to both income tax and FICA tax.
4. Virtual currency is self-employment income when mined, valued at its fair market value as of the date and time of receipt. This means that this income, net of expenses, is subject to both income tax and FICA tax.
5. Virtual currency is treated as wages if paid by an employer, valued at its fair market value as of the date and time of receipt. In theory, this income would be part of an employee's W-2.
6. A taxable gain or loss is created upon the exchange of crypto for other property, including other crypto. This means that if you think you've traded your Bitcoin for a computer, what has actually happened in Tax World is that you sold Bitcoin (taxable event) and with that money, you bought a computer.
7. The character of any gain or loss depends on how the property was held. Most taxpayers are holding cryptocurrency as an investment, so gains and losses will be capital. In the unlikely event that someone is operating as a dealer or exchange, though, it would be inventory.
8. Cryptocurrency received for mining, staking and validating is self-employment income if it rises to the level of a trade or business. Income is the value of the crypto received, as of the date and time of receipt. If it is a trade or business for the taxpayer, then this income is reported on Schedule C and expenses may be taken. If it's really just a hobby or side gig, it's Schedule 1 income and no expenses are taken.
9. Virtual currency is subject to all information reporting and withholding required by the IRS as if the payment was made in fiat currency. This includes 1099Ks, 1099-NECs, W-2s, etc.
10. Forks and airdrops are taxed as ordinary income, valued at the fair market value as of the date and time of access. This income is reported on Schedule 1 as other income.
11. Fees may be added to basis. This includes fees you paid to purchase the currency as well as fees you paid to sell it.
12. A charitable contribution of virtual currency may be treated as a contribution of appreciated property.
13. Permitted inventory methods are FIFO or specific identification. Other inventory methods are disallowed.

Most situations involving the taxation of virtual currency can be handled by one of these principles.

The IRS is well aware that many people are not reporting crypto activities on their tax returns and the Service is taking this very seriously. The John Doe Summons issue to Coinbase resulted in a series of letters being sent out to taxpayers who were “outed” by Coinbase. In 2021, the IRS issued John Doe Summons to Circle and to Kraken, so another series of letters is on the horizon. Don't fall into the trap of believing that the IRS is only interested in the big fish in the pond. They'd be more than happy to make an example of a small fish as well.

Take your cryptocurrency tax reporting seriously, because the IRS is certainly doing so.

The Crypto Question

The first thing you need to do is to correctly answer the so-called “Crypto Question” on the front page of the 1040. The IRS has been through a lot of iterations of this question. Here's the 2022 version: “At any time during 2022, did you: (a) receive crypto as a reward, award, or compensation; or (b) sell, exchange, gift, or otherwise dispose of a digital asset?”

Here's a summary of what activities should result in a YES to the question:

• The receipt of virtual currency as payment for goods or services provided;
• The receipt or transfer of virtual currency for free (without providing any consideration) that does not qualify as a bona fide gift;
• The receipt of new virtual currency as a result of mining and staking activities;
• The receipt of virtual currency as a result of a hard fork;
• An exchange of virtual currency for property, goods, or services;
• An exchange/trade of virtual currency for another virtual currency;
• A sale of virtual currency; and
• Any other disposition of a financial interest in virtual currency.

A No response is good if all you did was buy and hold, transfer crypto from one wallet that you owned to another wallet that you owned, or had no crypto activities at all.

Be aware that owning stock in a company that owns crypto - such as Coinbase or Greyscale Bitcoin Trust - does not mean you own crypto. It simply means you own stock. Similarly, owning stock in General Motors does not necessarily mean that you own a car.

Tax Forms

Next, pay close attention to any forms you might have received from exchanges; specifically, a 1099-MISC, a 1099-K, or a Form 1099-B. The IRS has copies of any forms you received, and their sophisticated software is going to be checking to make sure that you've reported that information correctly on your tax return. Remember, it isn't just a question of whether or not you reported the income – it's also a question of whether or not you reported it correctly.

So you'll need to understand exactly what that form is reporting in order to know where to put it on your tax forms. It could be that the form isn't correct, in which case you either have to contact the organization that created the form and ask for the correction (and good luck with that) or make the necessary corrections on the tax return itself.

Tax forms you can expect to use:

• Form 8949 to report sales and trades
• Schedule D to summarize your Form 8949 entries
• Schedule 1 to report hard forks, airdrops, rewards such as staking. and “interest” (Be aware that the so-called “interest” paid by exchanges isn't interest in the true sense of the word. Interest is money paid on the loan of money. If you're loaning crypto to an exchange, what you get in return for providing that liquidity isn't interest; it's just ordinary income reported on Schedule 1.)
• Schedule C if you're earning crypto in exchange for services you're providing.

Miners file Schedule C if their activity rises to the level of a trade or a business; otherwise, mining income is ordinary income reported on Schedule 1.

Remember that you can subtract expenses from income if you're using Schedule C. This isn't an option if you're reporting income on Schedule 1. On the other hand, income that is reported on Schedule C is subject to FICA tax, which isn't the case for Schedule 1 income. There are pluses and minuses to both scenarios.

Form 8949 is pretty straightforward. You really don't have to enter every single transaction if you did a lot of selling and trading; you can summarize the sales and trades and then attach a detailed list as a pdf. Simple enough.

The information on Forms 8949 then transfer to Schedule D. If you're using software, that'll happen automatically.

Note that there isn't a de minimis for digital assets; this means that all income is taxable, even if it's just $1.

Foreign Reporting

Taxpayers who have a financial interest in or signature authority over foreign financial accounts are required to file Report of Foreign Bank and Financial Accounts (FBAR) with the Financial Crimes Enforcement Network (FinCEN) if the aggregate value of those accounts exceeds $10,000 at any time during the calendar year. So does that mean that holding virtual currency in a foreign exchange requires the filing of an FBAR if the value of that account exceed $10,000 at any point during the year?

This was a good question without a good answer until December 30, 2020, when FinCEN issued the following statement:

Currently, the Report of Foreign Bank and Financial Accounts (FBAR) regulations do not define a foreign account holding virtual currency as a type of reportable account. (See 31 CFR 1010.350(c)). For that reason, at this time, a foreign account holding virtual currency is not reportable on the FBAR (unless it is a reportable account under 31 C.F.R. 1010.350 because it holds reportable assets besides virtual currency). However, FinCEN intends to propose to amend the regulations implementing the Bank Secrecy Act (BSA) regarding reports of foreign financial accounts (FBAR) to include virtual currency as a type of reportable account under 31 CFR 1010.350.

We don't know what the timing of this is going to be. We don't know if it's going to be retroactive. We only know that it's coming. At some point, crypto investors with $10K or more in a foreign account will be required to file an FBAR.

That reporting threshold is as follows: if you are unmarried, you must file the form is the total value of the assets on the last day of the year is more than $50,000 or the total value of the assets is more than $75,000 at any time during the year. Those numbers double for married taxpayers filing jointly.

The million-dollar question, of course, is whether or not digital assets held on foreign exchanges are considered foreign assets for Form 8938 purposes.

Instructions for the form talk about financial accounts maintained by a foreign financial institution; stocks issued by someone not a U.S. person; interests in a foreign entity; financial instruments or contracts that have an issuer or counterparty that that is not a U.S. person; notes, bonds, debentures, or other forms of indebtedness issued by a foreign person, an interest in a foreign trust or foreign estate, and more.

Digital assets are not mentioned in the rather long and comprehensive lists in the instructions. At this point, we simply don't know if Form 8938 is meant to be filed to report digital assets or not. There are opinions on the web on both sides of the fence. Certainly, the conservative approach would be to report such assets on this form.

Initial Coin/Exchange/Token Offerings

Via an ICO/IEO/ITO, a new digital currency or product is created and sold online, sometimes raising tens of millions of dollars in just minutes. The idea is that this new currency/product/whatever will become the latest virtual currency of choice or will be redeemable for services such as data storage. Just as with IPOs, the investor wants to buy in cheap at the starting gate with the hope that the investment will appreciate over time.

Payment to get into an ICO/ITO/IEO is usually made with an established virtual currency such as BTC or Ethereum. Your basis in the new coins is equal to your basis in the virtual currency with which you purchased those new coins. If you spent $10,000 worth of Bitcoin to buy AmyCoin, then your basis in the AmyCoin is $10,000. And don't forget that you now have a taxable event; you have essentially sold that $10,000 Bitcoin and you may therefore have a gain or a loss, depending on your basis in that Bitcoin.

As ever, record-keeping is essential.

NFTs

NFTs are complex when it comes to taxes for a few reasons. First, the IRS has issued exactly ZERO guidance on the subject. Second, the NFT itself can represent any of a number of different types of digital assets.

As a result, there isn't a one-size-fits-all when it comes to NFTs! The person who created and subsequently sold the NFT may have Schedule C income (and can take expenses against that income) or have Schedule 1 hobby income (no expenses allowed). The person who bought it and then resold it might have capital gain income (or loss) or business income or loss, depending on that person's situation. Gas fees must be factored into the equation when it comes to reporting gains and losses.

Reporting NFT transactions is complicated. It might not be a DIY project.

MMORPGs

Way back in May 2013, the Government Accountability Office wrote a report to the Committee on Finance, U.S. Senate, called Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks.

The report discussed MMORPGs (massively multi-player online role-playing games) with closed-flow economies, open-flow economies and hybrid economies. In a closed-flow economy, virtual goods and services can be traded in-game, but no opportunity exists to trade such assets for dollars. In an open-flow economy, dollars can purchase in-game assets and in-game assets can be sold for dollars. In a hybrid economy, dollars can purchase in-game assets, but in-game assets cannot be sold for dollars.

Today there are a huge number of online games and millions of people playing them. Are there tax issues for these gamers? Yes, and lots of them. Any time a taxpayer gets involved in one of these games, they're using cryptocurrency to buy in, so right off the bat we've got a sale of, typically, Bitcoin or ETH. If all the player does, after that initial purchase, is stay within the game and not purchase any additional assets, there are no further tax events.

However, a good number of these gamers buy additional assets — again, using cryptocurrency — and then may buy and sell assets via an in-game store, or outside the game using an NFT platform. Tracking the basis of sold assets may prove complex, since the gamer may not be tracking how much it cost to create that in-game asset. If a taxpayer sells a Kitty from CryptoKitties online, what did it cost that taxpayer to create that Kitty? Have they tracked how much Ethereum they put into that game? And can they segregate how much of that Ethereum was directly related to the creation of this particular Kitty? Again, it's not clear that the new reporting requirements will apply to NFT platforms, so tax preparers will have to figure all this out on their own.

This sort of tracking may be difficult; but, as we well know, just because something's hard to track doesn't mean that it isn't taxable. It may be that tracking the basis of in-game assets will be the next new multimillion dollar app.

Lots of Reporting!

The tricky thing about digital assets aka cryptocurrency is that pretty much anything you do throughout the year is a taxable event. Traded your BTC for XRP? Taxable event. Swiped your crypto debit card at the local Starbucks? Taxable event. Paid your made in crypto instead of dollars? Taxable event.

About the only thing you can do that isn't a taxable event is buy and hold. That's good news for all the hodlers out there.

Need Help?

Tucson Tax Team is here to help. We stay up-to-speed on the IRS' reporting requirements for digital assets so that you don't have to. Email [email protected] for more information.