16 - In this world, nothing is certain except death and taxes
Before I jump in I need to give a disclaimer. I am many things including an accountant, BUT I am not your accountant. Do not take anything I say in this piece as tax advice or an endorsement of your tax personal tax position. In the previous TTF piece, you were promised that this week would be about hacks and attacks. With April 15th fast approaching, it seemed timely to push that piece back a week and instead provide some insight into the current state of tax regulation .
Last week the Biden administration issued an Executive Order providing some guidance by which federal departments and agencies should be exploring the blockchain and digital asset space. One of my former colleagues, Jamison Sites, pointed out that something surprising was missing from this order: taxes. Biden directed the Department of Treasury to investigate digital assets’ impact on markets, directed the Department of Commerce to drive US competitiveness in development of teck, and even encouraged the the Federal Reserve to continue exploring CBDC’s (we will discuss these in a later piece), but he did not mention the Internal Revenue Service (IRS) once. From the layman's perspective, this is somewhat frustrating considering taxes are the area that the average American participating in the digital asset space is most concerned about.
Let’s talk taxes
The reason why tax professionals are surprised and, in most cases, disappointed about the lack of clarity in the Biden Executive Order is because there has been very little clarity from the IRS on how digital assets should be treated. To date, the IRS has issued one notice 2014-21 and published one FAQ on the topic of “virtual currency” taxation. The TLDR on these documents is that in the eyes of the IRS, digital assets should be considered property: and if you receive or sell a digital asset, it is a taxable event. With this in mind, let’s discuss some of the different scenarios someone investing in the digital asset space might find themselves in and how they could approach them.
Buy and sell - Crypto <> Fiat
The most common activity that investors will perform is the action of buying and selling. The investor takes $100 and buys a fraction of a bitcoin (BTC) with a current market price of $50,000. In such a transaction, an important term to understand is the concept of “cost basis.” Cost basis is the value that someone pays to acquire an asset. In our hypothetical, with the purchase of some BTC, the investor has obtained an asset for $100. In the eyes of the IRS, the investor simply transferred that $100 worth of cash into property.
Now let’s say the price of BTC increases from $50,000 to $60,000 making the original $100 investment now worth $120. The investor decides that 20% is good enough and decides to sell their BTC. Once the sale has been executed, the investor will walk away $20 richer than when they first invested. Unlike the buying of the asset, the sale of the asset has created a “taxable event.” The difference between what the investor bought the asset for (“cost basis”) and what s/he sold it for (sale value) is considered the value subject to taxation.
In our example, that taxable value was a “gain” of $20. When an investor has a gain, the entire amount of that gain will be considered as income and taxed. The income is in a different category called “income from capital gains/losses.” Capital gains income is different from the income a person receives from a paycheck. The IRS has different tax rates for different types of income depending on a number of factors. Talking to a tax advisor could be a good call for our investor.
The next question that must be asked is: “what if the asset does not increase in value, but decreases in value?” Instead of going from $50,000 to $60,000, it declined to $40,000. In this scenario, the original $100 invested would now only be worth $80. When the investor sells the BTC, it would still be a “taxable event”; but instead of incurring a gain, the investor would have suffered a “loss.” Uncle Sam isn’t an unfair guy; and if an investor suffers a loss, then they are allowed to actually reduce their capital gains by the amount lost. In this case, the reduction would be $20.
Buy and sell - Crypto <> Crypto
One of the more interesting characteristics of the digital asset markets is that you can move from one digital asset directly into another one. In traditional markets, if an investor wants to move from Apple into Amazon stock, they must sell the Apple stock for US dollars and then take those dollars and buy Amazon stock. There is no market by which to directly trade Apple stock for Amazon stock. Every market is the stock to US dollars. The crypto markets, however, do allow investors to make a move from one asset directly to another. Investors can go from bitcoin (BTC) into ether (ETH) without having to move into US dollars to do so. Whenever an investor is selling one asset and buying another whether that sale is into US dollars or into another digital asset, it is going to cause a taxable event.
Let's say that someone bought one BTC for $5,000 (god bless) and the price of BTC jumped 400% to $20,000. That investor then decides that they think ETH is going to provide higher returns over the next 6 months and wants to move out of BTC and into ETH. They go to the BTC/ETH market where they see a stated price of 1 BTC to 20 ETH. What this means is that for every 1 BTC the investor is able to obtain 20 ETH. The investor then makes the trade selling out of their 1 BTC for 20 ETH. Boom, a taxable event has occurred.
When the investor swapped their BTC for ETH they technically “disposed” of or sold the BTC. The market price of BTC at the time of sale was $20,000 and their cost basis was $5,000. This means that their taxable income was $15,000 ($20k market value less the $5k cost basis). Because the investor was moving from BTC into ETH they technically purchased a new asset which will now have a new cost basis. The cost basis for ETH is going to be $20,000 divided by the 20 ETH obtained or $1,000 per ETH. Even though the investor never actually touched cash they must report $15,000 worth of taxable income to the IRS.
Historically, some wiley investors have tried to argue that the move from one digital asset directly into another is not a taxable event because of a tax exemption known as 1049 like kind exchange. 1049 allows investors moving from one asset into an asset that is of a similar nature or like kind to postpone paying taxes on that sale. In years past, accounts might try and take this stance because the 1049 exemption was not very specific about what assets you could do this with. The Trump tax bill has since made it explicit that the 1049 exemption is for real estate transactions only.
NFT’s, airdrops, and gifts
Besides buying and selling digital assets for fiat or other digital assets, investors in this industry have a few other common events that occur. The first one is the purchase and sale of NFTs.
If there anything within the digital asset space 2021 will be known for it is non fungible tokens (NFTs). Most people know these tokens from the fun pictures associated with them. We have not discussed how NFTs are different then other digital assets such as bitcoin; but from the perspective of taxes, there is no difference. If an investor bought an NFT for cash, then your cost basis is what you paid. If that NFT increases in value and the investor sells it, the difference would be a taxable gain while if it lost value and you sold it, it would be a taxable loss. The same rules apply if an investor buys and sells an asset for another digital asset. These transactions would follow the same rules that have been outlined in the paragraph above.
Investors may also receive digital assets as either an airdrop or a gift. Airdrops are when an investor is sent a digital asset to their wallet. Most of the time this occurs because they are actively using the project's application or for promotional reasons (we can discuss these in more detail in the future). From a tax perspective, determining if an airdrop is a taxable event will depend on two factors:1) is there a market price for the asset on the day it was received; and has the investor then disposed of the asset. First, if there is a market value for the airdropped asset, meaning that you can find a price for that asset on an exchange like coinbase, then the value of that asset you received would be considered income. If the asset did not have a market value at the time it was sent, then the investor would consider the cost basis as being zero and record full taxable income at the time the asset is sold.
Gifts are a bit less complicated but still require some consideration. The IRS allows people to give up to $15,000 ($16,000 for gifts made in 2022) worth of gifts to a single individual over the year. That’s why when your grandparents give you $50 at Christmas, you don’t need to report that as income. Grandma can give you up to $14,950 more before you have to tell the IRS. (maybe let her know that next winter). If someone were to give an investor BTC as a gift, then the investor would need to record it as income if the value is above that $15,000 threshold. If the value of the BTC received is below that $15,000 mark, then the investor would not need to report anything. What is interesting about gifts is that the recipient of the gift also receives the giftors cost basis in the asset. If the person giving the gift had bought the BTC for $5,000, gave it to the investor when the market value was $10,000, and then the investor sold it when the market value was $12,000, then the recipient would pay taxes on $7,000 ($12k - $5k).
Taxes are hard and digital asset taxes are even harder. One way to avoid a tax headache is buying and holding your assets on an exchange. Be sure to consult a tax professional whenever dealing with complex topics like digital asset taxation.