Cryptocurrency: In This Evolving Market, Have You Considered Setting Up a Tax Strategy?
New York, NY — March 1, 2023
It's no secret that cryptocurrency adoption is growing worldwide and has become an increasingly popular investment, with more and more individuals and businesses investing in this evolving market. As of 2023, it is estimated that global crypto ownership rates at an average of 4.2%, with over 420 million crypto users worldwide.[1]The more practical applications that can use cryptocurrency, the more it will become popular over time. In the United States, most Americans view crypto as a risky investment. Younger generations with appetites for risk, however, appear to be more willing to take a chance on crypto investing.
Among the most important advantages of cryptocurrency are transaction cost, transparency, security, and diversification. While cryptocurrency use or investment may be attractive, the tax implications are often overlooked. As a result, many investors find themselves facing complex tax issues. Cryptocurrency taxation is still evolving and becoming more complex as governments and regulatory bodies around the world struggle to keep up. In this article, we will explain cryptocurrency tax concepts and how setting up a tax strategy can save you money.
What is Cryptocurrency?
Cryptocurrency is a digital or virtual currency in which transactions are verified and records maintained by a decentralized medium of exchange using cryptography, rather than by a centralized authority.
U.S. Taxation of Cryptocurrency
After the invention of Bitcoin, the first cryptocurrency, in 2009, for the first few years, there was little guidance in the United States concerning the federal income tax treatment of cryptocurrencies. But in 2014, the IRS released Notice 2014-21, which clarified that "virtual currency" is treated as property (not traditional currency — including paper money and coin that has legal tender status in any jurisdiction) for federal tax purposes and that general tax principles applicable to property transactions apply to virtual currency transactions.
In general, if cryptocurrency is held by the taxpayer as investment property, where the goal is to capture appreciation, then upon disposition the gain or loss would be considered capital. If the cryptocurrency is held by the taxpayer primarily for sale in the ordinary course of business, the gain or loss upon the sale of it would be considered ordinary.
How to Set Up a Cryptocurrency Tax Strategy?
1. Determine your tax filing status: First, you'll need to determine your tax filing status. This will help you decide which tax strategy is best for you. Businesses and individual investors can invest in cryptocurrency directly or under the umbrella of an LLC which combines the liability shield of corporations with the tax benefits of a partnership or sole proprietorship.
2. Calculate your taxable events: For U.S. taxpayers, transactions involving the sale or exchange of cryptocurrency are taxable events, requiring proper reporting on their tax returns.
3. Track your gains and losses: It's important to track your gains and losses from each transaction to ensure you are accurately reporting your taxable events.
4. Utilize tax loss harvesting: Tax loss harvesting is a strategy that allows you to offset some of your gains with losses to reduce your tax burden.
5. Consider a tax-advantaged account: If you are investing in cryptocurrency, consider doing so in a tax-advantaged account like a Roth IRA or a Traditional IRA to further reduce your taxable events. The tax benefits of doing such can be found in our previous PW Tax Alert. Some cryptocurrencies, like stocks, can be purchased in an IRA or 401(k). However, an employer-adopted 401(k) plan with employees will likely not allow for any alternative investment options per ERISA fiduciary rules.
6. Take advantage of the long-term capital gains tax rate: If you hold an investment for more than one year before selling it, you may be eligible for the long-term capital gains tax rate, which is typically lower than the short-term capital gains tax rate.
7. Consult a tax professional: Finally, it's important to consult a tax professional for specific advice tailored to your situation.
IRS Enforcement
The Internal Revenue Service has made clear that it plans to target more tax revenue from crypto-related transactions and from noncompliance. In connection, the IRS's enforcement efforts against cryptocurrency owners have significantly expanded in recent years. These efforts include equipping agents with tools to find and trace cryptocurrency transactions including compelling cryptocurrency exchanges to produce account holder information and find unreported crypto-related assets and transactions. Taxpayers who are audited by the IRS and found to have under-reported or misreported their taxable income from crypto-related transactions could face increased liabilities, interest, penalties, and in egregious cases where a taxpayer acted willfully, criminal charges or fines.
At Perelson Weiner LLP, we understand the complexities of cryptocurrency tax reporting. Our team can help streamline your accounting processes to ensure that you are properly reporting your investments to the IRS and are optimally reporting your investment activity on your tax return. If you have questions about cryptocurrency tax reporting, please contact your Perelson Weiner partner.
Contributors: Allen Schaefer, CPA, MBA, Dennis Zinkevich, CPA, MST, and Robert Charron, CPA