Bitcoin Part 2: Tax Planning and Strategies
Sitting on a pile of cryptocurrency gains? Wondering what the tax consequences might be for those gains? Maybe you are thinking of dipping a toe into the market and want to know what that means for you financially.
The IRS has given plenty of thought to this too, so don’t be caught off guard. This article looks at a few scenarios and possible tax implications. [Our article “Bitcoin Part 1” is found here. ]
Bitcoin, and all other cryptocurrencies, also called virtual currencies, are currently treated as property by the IRS. This contrasts with stocks, bonds, mutual funds and ETFs, which are treated as securities. While property and securities share many similarities, such as holding periods for long-term vs. short-term capital gains, cryptocurrencies, as property, hold one significant advantage over investments classified as securities and that is that cryptocurrencies currently are not subject to wash-sale rules.
For those unfamiliar with this term, a wash-sale happens when an individual sells or trades a security at a loss and within 30 days before or after that sale buys a “substantially identical” stock or security, or acquires a contract or option to do so. This rule basically prohibits an individual from selling a security at a loss for tax purposes and immediately buying it back. This rule currently doesn’t apply to Bitcoin or other cryptocurrencies.
The Infrastructure Investment and Jobs Act signed by President Biden on November 15, 2021, does include extremely broad provisions that will impact reporting of cryptocurrencies. The new reporting requirements won’t take effect until 2023, and at the time of this writing the IRS has not issued any regulations or guidance on how the new law will be implemented. Depending on IRS guidance or additional law changes by Congress between now and the 2024 tax season there is the possibility cryptocurrencies will be subject to wash-sale rules.
This distinction lends itself to an incredible tax planning opportunity. If you were fortunate enough to have significant realized gains in securities or cryptocurrencies during the year but also had cryptocurrencies with losses, you could potentially sell your cryptocurrencies with losses on December 31 to help offset your gains. Assuming you still have faith in those cryptocurrencies and expect them to go up in the future, you could buy them back. This would have no impact on your ability to deduct the losses you realized on December 31 – potentially saving you thousands in taxes and leaving you with a nearly identical portfolio.
Considering accepting Bitcoin as wages or payment for services you provided in relation to a trade or business? The fair market value of the bitcoins you received, in terms of dollars as of the date you received them, will be the amount reported as compensation to you. This compensation will be subject to all the regular FICA taxes and income taxes as would any traditional form of W-2 or self-employment (1099) compensation. The amount recognized as compensation now becomes your basis in those bitcoins, and the date received begins your holding period for determining short-term vs. long-term capital gains or losses when the bitcoins are eventually sold or used as payment.
Perhaps you’re looking to use Bitcoin or other cryptocurrencies to generate passive income for yourself. Lending out cryptocurrency can earn 3-12% or more in interest depending on the type of cryptocurrency lent and the platform used. This is treated just like any other interest income you would receive.
Cryptocurrencies also offer interesting opportunities in the form of gifting. They tend to follow the rules of other appreciated property when it comes to gift rules and taxes, and are considered noncash gifts and subject to limitations related to basis, fair market value, holding period, and gains and losses. Highly appreciated cryptocurrencies could also be used to fund a charitable remainder trust, similar to how highly appreciated real estate is used.
There are several pitfalls to be aware of when it comes to using cryptocurrencies, especially as it relates to recognizing gains and losses for tax purposes. Many people might not realize using Bitcoin or another cryptocurrency to pay for goods or services will cause them to recognize a gain or loss on that transaction for the difference between the fair market value of the goods or services received and their adjusted basis in the cryptocurrency exchanged.
However, the use of stablecoins to purchase goods and services will not result in a taxable gain or loss because the value of the stablecoins, a class within cryptocurrencies, is pegged to the U.S. dollar and doesn’t fluctuate like other cryptocurrencies.
Some individuals might think they can get around realizing a gain or loss on their cryptocurrency by exchanging one cryptocurrency for another, but this will also cause the individual to realize a gain or loss for the difference between the fair market value of the cryptocurrency received and the adjusted basis of the cryptocurrency given up. This is the case even if an individual is exchanging one cryptocurrency for stablecoins. All gains or losses must be recognized in U.S. dollars.
Individuals are always required to report taxable gains and losses to the IRS on their tax returns regardless of whether that information is also reported by a third party. You are ultimately responsible for keeping proper records and reporting that to the IRS on your tax return.
Don’t get caught off guard if you’re dealing in cryptocurrencies. Consult your tax adviser for how your buying, selling and/or gifting of cryptocurrencies could impact you and your tax obligations.
* This article is not a complete listing of all the details related to this tax topic and you should contact your CPA for a more detailed discussion regarding these items and how they may apply to your specific situation.
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