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Misreported Crypto Gains? Fix Mistakes Before It's Too Late

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What You Need to Know

  • Advisors should be on alert and take the time to catch up now, before the IRS toughens enforcement.

It’s no secret that all eyes seem to be watching cryptocurrency as we approach year-end—including the eyes of Congress and the IRS. As most advisors know, the basic tax rules that apply in the world of virtual currency are the familiar rules that govern sales and exchanges of any other form of property. 

Today, however, it’s more important than ever to be up to speed on the cryptocurrency tax and reporting rules. Congress tightened the reins even further in the Infrastructure Investment and Jobs Act of 2021. The popularity of virtual currency has grown exponentially in the last year alone — and IRS enforcement efforts are only going to increase alongside that popularity.

Advisors should be on alert and take the time to catch up now, before it becomes too late to fix clients’ mistakes in reporting cryptocurrency gains. 

Virtual Currency: The Basics

In 2019, the IRS started a campaign to raise awareness among taxpayers who they believed to have engaged in cryptocurrency transactions. Many of your clients may have received educational letters. Now, via the Operation Hidden Treasure program, the IRS has increased enforcement efforts to identify unreported income — seizing over $1.2 billion in cryptocurrency during 2021 alone.

Cryptocurrency is a type of virtual currency that uses cryptography to offer secure transactions that are recorded in a type of online ledger (such as blockchain). Bitcoin, Ethereum and Litecoin are all examples of cryptocurrency.

When cryptocurrency is sold or exchanged, taxpayers must report any gain or loss in the same manner as any other property transaction (i.e., in the same manner as a stock sale). Gain or loss is measured by the difference between the taxpayer’s adjusted basis in the cryptocurrency and the amount received, measured in U.S. dollars.

The actual tax treatment depends on the nature of property. When a taxpayer exchanges a capital asset for cryptocurrency, the taxpayer recognizes a capital gain or loss (short-term or long-term, depending on whether the property has been held for at least one year). If other property is exchanged, ordinary income tax treatment may apply.

When cryptocurrency is received as payment for services, the value of the cryptocurrency is self-employment income or wages and subject to self-employment taxes (measured in U.S. dollars), FICA and FUTA.

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Complying With IRS Tax and Reporting Rules

Employers who compensate employees with cryptocurrency must report those wages paid on the employee’s Form W-2.

When it comes to mining transactions, however, cryptocurrency isn’t reported to the IRS on Form W-2 or a 1099. That doesn’t mean the client has no reporting obligations. Instead, the client should keep detailed records of the transaction, including the date and the fair market value of the cryptocurrency that has been mined.

The tax treatment will depend on whether the “mining” activities constitute a business or hobby in the eyes of the IRS. Classification generally depends on the amount of time the taxpayer spends on the mining activities and the client’s profit motivation. The profits will either be taxed as ordinary income or self-employment income if the activities amount to a business (in which case, it’s possible that business-related deductions may be available).

Foreign accounts that hold virtual currency will likely also be required to comply with FinCEN reporting rules. In other words, an FBAR filing may be required going forward.

Under the new law, cryptocurrency “brokers” that provide services “effectuating” digital asset transfers will be required to disclose their customers’ identities on a 1099-like form. Companies and exchanges will also be required to file a report anytime they receive over $10,000 in cryptocurrency. The recipients in the transaction would also be required to verify personal information, record his or her Social Security number and report the transaction within 15 days. 

While proposals are already in the works to narrow these requirements, it’s far from certain whether they’ll become law (the current issue is whether the law, as drafted, would require parties like software developers or miners to report information that they typically don’t have).

Conclusion

The bottom line is that the IRS is watching cryptocurrency carefully. Clients who engage in cryptocurrency transactions should keep extremely detailed records that include the cost basis of the cryptocurrency, the date of any transactions and the fair market value of the cryptocurrency exchanged or sold to prevent problems in case of an audit.

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