How Are Digital Assets Taxed?

Bitcoin and various succeeding digital assets have been around for over a decade yet there is still ambiguity regarding their treatment for U.S. federal income tax purposes. Two Ocean Trust CFO, Alex Duncan, breaks down what we know about the taxation of digital assets.

In 2014 the IRS issued its Virtual Currency Guidance Notice the purpose of which is to describe how existing tax principles apply to transactions involving digital assets.[1] More recently, the IRS issued its 2022 Tax Year Guide which further clarifies how digital assets will be treated for federal income tax purposes. Per the Tax Guide, the IRS defines digital assets as any digital representation of value recorded on a cryptographically secured distributed ledger or any similar technology including non-fungible tokens (NFTs) and virtual currencies such as cryptocurrencies and stablecoins. Additionally, in what appears to be an effort to quell any further ambiguity, the Tax Guide provides that any particular asset which has the characteristics of a digital asset will be treated as a digital asset for federal income tax purposes.[2]

How Are Digital Assets Treated for Tax Purposes?

The 2022 Tax Guide is silent with respect to the characterization of digital assets, and therefore taxpayers should still rely on the previously published Notice which states that digital assets are treated as property for federal income tax purposes.[3] Accordingly, existing tax principles which apply to property transactions are applicable to digital assets.

Capital Gains and Losses. Taxpayers who dispose of any digital asset, which they held as a capital asset, through a sale, exchange, gift, or transfer, must recognize a capital gain or loss. A capital gain will be triggered if the fair market value of the property received by the taxpayer exceeds the tax basis of the digital asset disposed. Likewise, taxpayers recognize a capital loss if the fair market value of the property received is less than the tax basis of the digital asset.[4] If the digital asset is held for one year or less, the gain or loss will be treated as a short-term capital gain or loss. If the digital asset is held for more than one year, the gain or loss will be treated as a long-term capital gain or loss. Events which trigger capital gains and losses include selling, transferring, gifting, and exchanging. Exchanging includes paying for goods, services, or other property with digital assets. Non-taxable events include buying digital assets with real currency, holding a digital asset in a wallet or account, transferring between wallets or accounts, and donating digital assets to a tax-exempt organization.

Gross Income. Taxpayers who receive digital assets as compensation for services or disposed of any digital asset that they held for sale to customers in a trade or business, must report the income as they would report other income of the same type (for example, W-2 wages on Form 1040 or 1040-SR, line 1a, or inventory or services from Schedule C or Schedule 1). The amount subject to tax is the fair market value of the digital assets received or disposed of, as of the date of receipt or disposition. Taxable events which are treated as ordinary income include the receipt of digital assets from mining, staking, airdrops, and as a result of a fork.

Tax Implications of Common Digital Asset Transactions

Mining. Digital assets received from mining as a hobby are treated as ordinary income for federal income tax purposes. The fair market value of mined digital assets at the time of receipt must be added to gross income and taxed as ordinary income. Digital assets received from mining as a business should be reported as such (on Schedule C of Form 1040) and will be subject to self-employment taxes accordingly. Taxpayers who mine as a business can deduct certain business expenses such as equipment and electricity costs. When mined digital assets are later sold or spent, taxpayers must also recognize capital gains or losses calculated as the difference between the tax basis and the value of the digital assets at the time of disposition.

Staking. Staking involves pledging digital assets to support blockchains that use “proof of stake” consensus mechanisms. In exchange for staking digital assets, lenders earn a percentage-rate reward over time. The IRS treats the receipt of digital assets as a reward for staking the same as mining, and therefore recipients must report and pay taxes on the value of staking rewards in the same manner as mined digital assets, as outlined above.

Borrowing. The receipt of cash in exchange for collateralizing your digital assets is non-taxable. The same holds true for spending loan proceeds and repaying loan principal. The lender charges interest on the principal generating interest expense for the borrower, which may or may not be deductible depending on the use of proceeds. Interest expense may be deducted against taxable income if the loan proceeds are used for investment or business purposes (e.g., investing proceeds into additional digital assets or traditional securities).

Lending. Taxpayers may lend their digital assets and receive interest income in exchange. This may be structured as a loan directly to a borrower or a pool of borrowers typically managed by a decentralized app. Interest income may be paid in cash or in-kind. Either way, the fair market value of interest earned is taxable as interest income in the year of receipt.

Wash Sales. As noted above, the IRS treats digital assets as property for federal income tax purposes. The term “property” can vary for tax purposes and may include money, currency, securities, commodities, or other types of property under the Internal Revenue Code of 1986. The IRS has yet to issue guidance on what specific type of “property” digital assets represent, and therefore it is not clear whether a digital asset should be treated as a security or a commodity.[5] Regardless, digital assets do not appear to be treated as securities for federal income tax purposes at this time because they do not have the characteristics of financial contracts which are deemed securities (e.g., a counterparty or attached rights).[6] Therefore, it seems likely that digital assets are excluded from Section 1091 thus allowing taxpayers to sell at a loss and immediately re-establish their position while still being allowed to deduct the loss from sale.

Tracking Tax Basis in Digital Assets

For U.S. tax purposes, digital asset transactions must be reported in U.S. dollars and taxpayers are required to determine fair market value at the time of purchase or receipt. If a digital asset is purchased with U.S. dollars, a taxpayer’s basis will be equal to the amount paid, including certain costs to acquire the digital asset. If a digital asset is received as payment for goods or services the basis is determined by the fair market value of the digital asset in U.S. dollars at the time of receipt. Fair market value in this instance is determined by reference to exchange rates or, if the digital asset is not traded on an exchange, the value in U.S. dollars of the services rendered.[7]

Moreover, the IRS views each separate coin, token, or unit of a digital asset as having its own tax basis and therefore, taxpayers should track tax basis on a unit basis. The IRS provides that taxpayers may track the basis of a specific unit of digital assets either by documenting its unique digital identifier such as a private key, public key, and address, or by records showing the transaction information for all units of a specific digital asset. This information must show (1) the date and time each unit was acquired, (2) the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.[8] In event that cost basis cannot be properly verified, most accountants will recommend reporting a value of zero, hence the importance of keeping thorough records of purchase dates and prices.

Tax Reporting and Compliance

Page 1 of Form 1040 requires taxpayers to disclose whether they (a) received (as a reward, award, or payment for property or services); or (b) sold, exchanged, gifted, or otherwise disposed of a digital asset (or any financial interest in any digital asset) at any time during the tax year.[9] If the answer is yes, additional information may be required on supporting schedules. Additionally, the 2021 American Infrastructure Bill requires exchanges to provide IRS Form 1099-B to track the disposal of digital assets starting in 2023. Information including gross proceeds, cost basis and capital gains and losses are reported on the form. Accordingly, understanding what types of transactions involving digital assets are considered taxable, and how to track basis and determine value for purposes of computing gains and losses is crucial.

State Income Tax Considerations

In addition to federal taxes, certain states impose tax on gains recognized from digital asset transactions. Some states, however, do not impose such taxes at the state level. Wyoming, for example, has no state income, capital gains, gift or estate tax, a benefit which may be extended to non-residents who place digital assets in a Wyoming non-grantor trust.

Conclusion

While the IRS provides guidance as to tracking and reporting digital asset transactions, uncertainty remains around the taxation of digital assets. Nonetheless, it’s clear that the IRS intends to capture digital assets within the broader tax net and taxpayers should be diligent about tracking the basis of their digital assets and properly reporting digital asset transactions.

In the wake of recent events in digital assets markets, including the crash of the Terra’s stablecoin and Luna Tokens, and the bankruptcy of crypto lender Celsius, we expect heightened focus on digital assets from various government agencies. Eventually US federal legislation and regulatory oversight will provide taxpayers with greater clarity around the implications of transacting in digital assets, but until that time taxpayers should remain diligent and err on the side of conservativism.[10]

About Us

Two Ocean Trust provides a full range of trust and investment capabilities to high-net-worth families including the first wealth management platform to seamlessly bridge traditional securities, alternative investments, and digital assets.

Based in Jackson Hole and regulated by the Wyoming Division of Banking, Two Ocean Trust is uniquely positioned to provide access to Wyoming's low tax rates, favorable trust laws, and unparalleled privacy and legal protections.

Notes:

[1] IRS, Notice 2014-21, 2014-16 I.R.B. 938 (4/14/2014).

[2] IRS Form 1040 (1040-SR) Instructions (draft as of 10/17/2022).

[3] Notice 2014-21, Section 4, Q-1 / A-1.

[4] Notice 2014-21, Section 4, Q-6 / A-6.

[5] A bipartisan bill has been introduced in the U.S. Senate which would make a clear distinction between digital assets that are securities and commodities by looking at the purpose of the asset and the rights or powers it conveys the consumer. Under the bill, Bitcoin and Ether would be characterized as commodities and regulated by the CFTC. See the Responsible Financial Innovation Act, sponsored by US Senators Cynthia M. Lummis (R-WY) and Kirsten Gillibrand (D-NY).

[6] Note that there are some situations in which virtual currency positions—such as certain initial coin offerings (ICOs) and certain tokens—are treated as securities under SEC rules and court decisions. See SEC, Report of Investigation Pursuant to §21(a) of the Securities Exchange Act of 1934; The DAO, Securities Act Release No. 81207 (July 25, 2017); and McDermott, Will & Emery, Andrea S. Kramer, Can a Virtual Currency Position be Treated as a Security for tax Purposes? (June 10, 2020).

[7] Notice 2014-21, Section 4, Q-4 / A-4.

[8] IRS, Frequently Asked Questions on Virtual Currency Transactions, Question 40.

[9] You have financial interest in a digital asset if you are the owner of record of a digital asset, or have an ownership stake in an account that holds one or more digital assets including the rights and obligations to acquire a financial interest, or you own a wallet that holds digital assets.

[10] Taxpayers should always consult a qualified accountant and/or attorney regarding the appropriate reporting of digital assets transactions. Also, tax laws frequently change, and circumstances should be continually evaluated.