CRYPTOCURRENCY TAXATION

Written By Donovan Thiessen, CPA

At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency? Yes or No?

You might have been asked this by your CPA while your prior year income tax return was being prepared. You might (you should) be asked this same question this year, because this is a question that you must answer on page 1 of your Form 1040 Federal income tax return. As you sign the income tax return, do not forget your attestation: “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which the preparer has any knowledge.”

The IRS uses the term “virtual currency” to define the various types of intangible, digital assets more commonly known as cryptocurrency. The most popular cryptocurrencies are bitcoin, ethereum, and dogecoin. I’ve seen a sharp increase in this activity over the recent two years. Unfortunately, there appears to be a common lack of understanding on how these assets are treated for income tax purposes. Although the online exchanges are providing better reports to assist with income tax preparation, the average person is trading these in a way that creates unforeseen complexities for tax reporting. This can cause unexpected, additional, fees for accounting and income tax preparation. Worse, it can cause surprise tax liabilities and draw scrutiny from the IRS. This article will give you an insight into the accounting and taxation of trading cryptocurrencies and will improve your organization and record keeping for this activity.

The IRS has increased its enforcement efforts for virtual currency transactions in recent years. On the current income tax return, they ask the first question in this article immediately after asking your name and address. In other words, it is a headline level question. Reading it closely, it does not ask if you merely purchased virtual currency. If that is all that you did during the calendar year in question, then you may answer “no.” Otherwise, if your answer is “yes,” you might be surprised as the way that you need to organize your activities.

Virtual currency is considered property by the IRS. 3This is the same as stocks, bonds, gold and silver bullion. These assets typically are inventoried and can be identified as to the quantity, original price (cost basis), and the date they were acquired and sold. Look at your annual tax statement from your broker that reports stocks sold during the calendar year. It will show this data, and you will report it as capital gains and / or capital loss on your income tax return, subject to capital gains taxation rules. The IRS has recently required cryptocurrency exchanges to report trading activity on annual 1099 forms to the IRS and provide copies to the taxpayer. This is helpful for the IRS to see who is trading, but is it helpful data for the taxpayer?

A taxpayer generally recognizes capital gain or loss on the sale, exchange, or disposition of virtual currency. Let’s review a few examples of different transactions, where the starting point is the purchase of 1 bitcoin in March 2020 for $10,000. If you sold it for $55,000 in April 2021, you must recognize $45,000 (55,000 – 10,000 = 45,000) in long term capital gains for income tax purposes. Alternatively, let’s say you traded the bitcoin for a vehicle valued at $50,000, and $5,000 cash. In this case you also have $45,000 in capital gains. If you traded the 1 bitcoin for $55,000 worth of other cryptocurrencies, then once again you have capital gains of $45,000. For simplicity purposes, you may owe income tax of 45,000 x .15% = 6,750 on each of these transactions. For the latter two examples, you can see where this might be a surprise.

It is the second example that has emerged as a major challenge for many crypto traders. Trading cryptocurrencies for other cryptocurrencies creates issues with the accounting of the inventories. A complete inventory should contain the following data:

• Quantity owned, separately sorted by specific asset type

• Cost basis of assets purchased or,

• Fair Market Value of cryptocurrencies received in exchange for cryptocurrencies given up,

• By date purchased or received, in chronological order. Commonly referred to as the First In First Out method. This is the default method of inventory accounting.

• Sale or exchange assets need to record the sale date and proceeds received. To determine the gain or loss, you pair the sale or exchange with the oldest inventoried assets.

• The ending inventory by asset type must be tracked on an ongoing basis, but certainly on an annual basis.

The complexity involved to create a complete and accurate accounting for your cryptocurrency activity and inventory might surprise you. I’m seeing taxpayers trading cryptocurrencies across multiple exchanges that includes purchases, sales, exchanges and furthermore withdrawals to offline cold storage wallets. I am seeing assets withdrawn from exchanges and then re-deposited back to an exchange, and other exchanges. The inventory accounting needs to be organized by cryptocurrency type, no matter where the asset is held (multiple wallets that are online or offline). For instance, at the end of 2021, I need to know the aggregate quantity of bitcoin owned, as well as ethereum and any other cryptocurrencies

owned. Due to trading on multiple exchanges and buying and trading of multiple cryptocurrency types, taxpayers are unknowingly causing their accounting to be complex and time consuming to prepare. As in the prior examples, not only can this create surprise tax liabilities, but it may also create surprise accounting and tax preparation fees. Further, I have seen crypto assets liquidated to pay for these taxes and accounting fees, which may result in additional taxable gains. In some cases, there are 10, 20 and even 100 cryptocurrencies owned, each with a First In, First Out inventory that needs to be tracked from inception to present and ongoing.

Considering these complexities, I recommend that taxpayers attempt to keep their trading as clean as possible. Some tips:

• Use a single exchange.

• Buy cryptocurrencies with the US Dollar (USD).

• When you want to sell, get the proceeds in USD.

• When you want to exchange one cryptocurrency for another, instead of exchanging them, sell the asset first, and use the USD proceeds to buy the new asset.

• When sales produce a capital gain, be sure to have some liquidity denominated in USD so that you can pay income taxes on the gain.

• Be strategic with withdrawals and deposits. If possible, do these in batches in repeatable sequences such as only at the end of the month. Make notes for the accountant to reference.

• Use software such as Zen Ledger to track your assets and trading activity. Be sure to include assets that are held in an offline storage wallet.

President Biden’s failed Build Back Better bill included a provision that could make the accounting and taxation for cryptocurrencies much more complicated. Although it did not pass, this provision will likely resurface. Disallowed losses from “wash sales” are common with stock sales in which a stock is sold and then repurchased within 30 days. A wash sale is not illegal, but the loss associated with that sale is disallowed and instead, the cost basis is typically adjusted higher for the disallowed loss. Eventually when that security is sold again, it will have a higher basis. Cryptocurrencies are not subject to wash sale rules. When this rule eventually changes, it will cause traders to adjust their cost basis and ultimately create additional complexities to the accounting records.

It appears that virtual currencies are here to stay. With increased IRS scrutiny, taxpayers are increasingly getting into compliance with their tax reporting requirements. Be sure to ask your tax professional how you can streamline your trading and record keeping activities to keep this part of your income tax clean and easy to review and understand. In the long run it will save you money on the tax reporting compliance side of your cryptocurrency trading activities

Donovan Thiessen, CPA is the founder and owner of The Accountant, LLC. Our mission is to help business owners make better decisions by providing timely and accurate financial and tax analysis. You may reach Donovan at donovan@theaccounantcpa. com, www.theaccountant.cpa and 702.389.2727.