Tax Treatment of Digital Assets

The Internal Revenue Service (IRS) issued the Virtual Currency Guidance Notice in 2014, providing insights into the tax implications of transactions involving digital assets. In the subsequent 2022 Tax Year Guide, the IRS further clarified the treatment of digital assets for federal income tax purposes. This article explores the tax treatment of digital assets, including cryptocurrencies, stablecoins, and non-fungible tokens (NFTs), as well as the reporting obligations imposed on taxpayers.

Tax Treatment of Digital Assets

Digital assets are treated as property for federal income tax purposes, as established in the IRS Notice.[1] Consequently, the existing tax principles applicable to property transactions extend to digital assets.

Capital Gains and Losses. When taxpayers dispose of digital assets they held as capital assets through sales, exchanges, gifts, or transfers, they must recognize capital gains or losses. A capital gain occurs when the fair market value of the received property exceeds the tax basis of the digital asset disposed, while a capital loss occurs when the fair market value is lower. The duration of holding the digital asset determines whether the gain or loss is classified as short-term or long-term.

Gross Income. Taxpayers who receive digital assets as compensation for services or who sell digital assets held for sale to customers must report the income. The taxable amount is the fair market value of the digital assets received or disposed of at the time of receipt or disposition. Events such as mining, staking, airdrops, and hard forks can trigger ordinary income treatment.

Tax Implications of Common Digital Asset Transactions

Mining. Mined digital assets received as a hobby are treated as ordinary income, while those received as a business should be reported as such. Taxpayers engaged in mining as a business can deduct certain business expenses and must also recognize capital gains or losses when selling or spending mined digital assets.

Staking. Staking digital assets for blockchains that utilize proof-of-stake mechanisms results in similar tax treatment as mining. Staking rewards are considered ordinary income and subject to reporting and taxation.

Borrowing. The deductibility of interest expense depends on the purpose of the loan proceeds. If the loan proceeds are used for investment or business purposes, such as investing in additional digital assets or traditional securities, the interest expense can be deducted against taxable income

Lending. Interest received from lending digital assets is taxable as interest income in the year of receipt.

Hard Forks. If a taxpayer owns a legacy cryptocurrency and there is a hard fork without receiving units of a new cryptocurrency, it does not generate gross income for the taxpayer. However, if there is an airdrop of a new cryptocurrency after a hard fork and the taxpayer receives units of the new cryptocurrency, it will result in gross income for the taxpayer, which is considered ordinary in nature.

Wash Sales. The IRS treats digital assets as property for federal income tax purposes, but it has not clarified whether they are considered securities or commodities.[2] As a result, digital assets are currently excluded from Section 1091, allowing taxpayers to sell at a loss and immediately re-establish their position.

Non-Taxable Transactions. 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 are examples of non-taxable transactions.

Tracking Tax Basis in Digital Assets

For tax purposes, digital asset transactions must be reported in U.S. dollars, and taxpayers need to determine the fair market value at the time of purchase or receipt. Each unit of a digital asset is considered to have its own tax basis, and taxpayers should maintain records of acquisition dates, fair market values, and transaction information. If the cost basis cannot be verified, accountants will recommend reporting a value of zero. This underscores the significance of maintaining comprehensive records of purchase dates and prices.

Tax Reporting and Compliance

Individual taxpayers must disclose their digital asset transactions on Form 1040 if they received or disposed of digital assets during the tax year. Brokers, as defined under the Infrastructure Investment and Jobs Act, may be required to track and report digital asset transactions, subject to forthcoming regulations.[3]

The Financial Crimes Enforcement Network (FinCEN) has stated that a foreign account holding digital assets is not a reportable account unless it holds additional assets which are reportable. However, FinCEN has indicated its intent to amend the regulations to include digital assets as a type of reportable account. Accordingly, it is likely that foreign accounts holding digital assets will be reportable in the future.

State Income Tax Considerations

In addition to federal taxes, certain states impose taxes on gains from digital asset transactions. However, some states, like Wyoming, do not levy such taxes. This benefit may be extended to non-residents who place digital assets in a Wyoming non-grantor trust.

Conclusion

While the IRS has provided guidance on tracking and reporting digital asset transactions, uncertainties remain regarding their taxation.[4] Taxpayers should remain diligent in tracking the basis of their digital assets and reporting transactions properly. As federal legislation and regulatory oversight develop, taxpayers can expect greater clarity, but until then, a conservative approach is advised.

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About the Authors

Alex Duncan is CFO of Two Ocean Trust a Wyoming Chartered Trust Company based in Jackson Hole providing a full range of trust and investment capabilities to ultra high net worth families and foundations. Alex has over 10 years of experience in public accounting and consulting. Prior to joining Two Ocean Trust, Alex worked in the transaction advisory groups of Ernst & Young and Alvarez and Marsal where he advised clients on all aspects of domestic and cross-border acquisitions including due diligence, acquisition structuring, and capital structure.

Joel Revill is CEO of Two Ocean Trust a Wyoming Chartered Trust Company based in Jackson Hole providing a full range of trust and investment capabilities to ultra high net worth families and foundations. Joel serves on numerous boards for the firm's private trust company clients as well as corporate and non profit organizations nationally. Joel was appointed by Governor Gordon to the Wyoming Legislature's Select Committee on Blockchain and Financial Technology and chairs the Selection Panel for Wyoming's Investment Funds Committee which oversees the state's $26 billion sovereign funds.

Notes:

[1] Various guidance published by the IRS since the Notice has been silent with respect to the characterization of digital assets, and therefore we believe taxpayers should rely on the Notice which states that digital assets are treated as property for federal income tax purposes.

[2] There are certain situations in which virtual currency positions 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).

[3] If regulations follow recent amendments to the Infrastructure Investment and Jobs Act, then disclosure may be required for broker transactions beginning after December 31, 2022.

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