Cryptocurrencies, or as the IRS calls them “virtual currencies,” are taking the world by storm. More and more investors are eagerly trying to profit from the volatility of the crypto market and earn a return on their investment. However, investors need to be wary of federal agency approaches to crypto investments and whether their activities trigger any crypto tax reporting requirements.
5 tax tips for cryptocurrency investors
Investors need to be familiar with the history of IRS policies and publications regarding virtual currencies.
The IRS guidance on “virtual currency” dates back to 2014. In 2014, the IRS issued its 2014-21 Notice, which clearly asserts that virtual currency transactions are treated as property for federal income tax purposes. In defining the purpose of a virtual currency, this notice describes a virtual currency as a digital representation of value that may serve one or more of the following purposes: (1) a medium of exchange; (2) unit of account; and (3) store of value.
As the IRS began to realize that the nation was facing a significant underreporting problem regarding virtual currencies, it issued a reminder bulletin to US taxpayers in 2018. This bulletin urged taxpayers to report their virtual currency transactions or face criminal charges. In 2019, the IRS issued press release IR-2019-132, noting that the agency had sent over 10,000 letters to taxpayers for not reporting all of their virtual currency transactions or for inaccurately reporting such information. Finally, beginning with the 2019 tax year, the IRS added a very specific question to Form 1040: “At any time during [the taxable year]have you received, sold, sent, exchanged or otherwise acquired a financial interest in virtual currency?”
Various cryptocurrency transactions trigger tax reporting obligations, sometimes both at the time of receipt and at the time of sale or disposal.
Before investing large amounts in cryptocurrency and then exchanging, selling or disposing of it in hopes of gaining a profit, investors need to understand that such actions trigger tax and reporting obligations. Depending on the type of cryptocurrency or “virtual currency” transaction, this could mean creating a taxable event that generates either ordinary income or capital income. In addition to the obvious reporting requirements associated with selling or exchanging virtual currencies, other activities such as selling or receiving airdrops, revenue from Initial Coin Offerings (“ICOs”), or coin mining also give rise to tax reporting requirements.
In this sense, cryptocurrency mining is a special topic. Crypto mining triggers two taxable events. The first tax event occurs when the taxpayer mines the cryptocurrency and thus receives a new coin as a reward for being the first to successfully verify the transaction. This is reported as ordinary income. The second tax event occurs when the taxpayer elects to sell, barter, or otherwise dispose of that cryptocurrency at a later date. This is accounted for as a capital gain or loss and can be short or long term depending on how long the taxpayer held the cryptocurrency. Finally, individuals operating as a mining company can claim standard business deductions under Section 162 of the IRC.
The crypto tax reporting process for crypto investors is both nuanced and dependent on multiple factors such as business type, hobby versus business income, and filing status.
Reporting your own virtual currency transactions involves multiple forms and multiple steps. The first question to ask is whether they were actually involved in a virtual currency transaction. Once you have done that, the next question is whether these transactions are ordinary or capital in nature. To answer this question, the purpose of the transaction, the nature of the transaction and the holding period must be examined. For example, revenue from ICOs is common, while selling cryptocurrencies held for over a year is capital. After the taxpayer determines the holding period, the transactions are settled and the taxpayer completes IRS Form 8949 Sales and Other Dispositions of Capital Assets. The amount of the taxpayer’s capital gains and capital losses – including from cryptocurrency sources – is also transferred to Form D. If the taxpayer has any virtual currency transactions that resulted in ordinary income, that will also be reported, but the form used may differ (Appendix 1 for hobby income; Appendix B for earned interest; and Appendix C for businesses). Without the proper guidance from a tax attorney or CPA experienced in virtual currency reporting, this process can be quite cumbersome.
The IRS can institute criminal proceedings against individuals and investors for failing to report or incorrectly reporting “virtual currency” transactions.
The IRS has recently increased its efforts to investigate and refer law enforcement individuals involved in criminal cryptocurrency tax fraud. The IRS believes that more resources need to be devoted to preventing tax fraud and crime, particularly in relation to cryptocurrency markets that are already characterized by lax or no regulation. Crimes such as money laundering, terrorist financing, wire fraud, cyberattacks, and ransom payments are on the rise due to the pseudonymity of crypto transactions and more lenient AML/KYC laws. In addition to preventing these crimes, the IRS seeks to investigate those who misreport their virtual currency earnings or who intentionally fail to report their virtual currency transaction earnings.
Finding law firms, attorneys and tax professionals with experience in legal matters, tax reporting and cryptocurrencies can be a very challenging task.
Not many law firms are experienced in dealing with cryptocurrencies and crypto trading, let alone their tax reporting obligations. Because of this, crypto investors must do their own research and ask questions before hiring a law firm or CPA to solve their cryptocurrency-related problems. In addition to filing your taxes, a tax attorney, tax professional, or CPA can help you in other ways, such as: B. by giving you an overview of the current treatment of cryptocurrency transactions by the IRS. Other matters a tax attorney can assist you with include developing a comprehensive compliance program or creating detailed AML/KYC policies for your business. Additionally, an attorney experienced in cryptocurrency matters is not limited to helping you with tax and IRS issues. They may also be able to advise you on legal issues under the Federal Securities Act, the Investment Adviser Regulations, the FinCEN Rules and the Bank Secrecy Act.
“Many investors are eager to invest in cryptocurrency opportunities. At the same time, the investor will incur a significant loss if they fail to perform proper due diligence or fully understand the nature of the crypto market, tax reporting requirements, or federal agency positions on cryptocurrencies. Hiring a cryptocurrency-experienced law firm can reduce your exposure to liability and increase your compliance efforts.” —Dr. Nick Oberheiden, founding attorney of Oberheiden PC
Cryptocurrency investors must consider the above factors in order to fully understand the inherent nature of cryptocurrency investments and to enable investors to make informed decisions to protect their investments. By thoroughly studying the history of IRS guidance, tax reporting triggers, the tax reporting process itself, the IRS and criminal procedures, and tips on finding a law firm, crypto investors are better prepared to manage their cryptocurrency investments.
Oberheiden PC © 2022 National Law Review, Volume XII, Number 59