Digital Assets – What to Know Ahead of the 2022 Filing Season

Digital assets are a rapidly evolving area. Taxing authorities are playing catch-up to understand the industry and how to apply current tax law to these transactions. However, just as there are many unknowns in the world of cryptocurrency and NFTs, there are many unanswered tax-related questions too. Here are several digital asset tax considerations for the investors, the collectors and the curious as we close out the year.

Reporting

The IRS added a question to the individual income tax return about cryptocurrency ownership in 2020, then altered that question in 2021, and has now proposed new changes to the question again. The draft 2022 individual income tax return question now reads: “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?” One key change to note is the mention of a “gift.” Typically, the IRS does not require notification of gifts below the annual gift exclusion amount, which for 2022 is $16,000. If a gift is made for an amount less than the $16,000 annual exclusion threshold, but that gift is in cryptocurrency, does that have to be disclosed? More guidance is needed to better define the term “gift” in this context.

In addition, with respect to the updated tax return question, outside the normal course of buying Bitcoin and Ethereum on an exchange, there are certain investment products that do require a taxpayer to answer “yes” without directly selling stock. For example, some investment companies allow individuals to invest in certain trust structures which hold cryptocurrency. These investments are treated as grantor trusts for tax purposes, meaning a trust’s income and expenses “flow through” directly to the individual investors. In these scenarios, there could be nominal amounts of cryptocurrency sold through the trust to cover the expenses of the trust. Yet, these amounts are not reported to investors on a formal tax document such as a 1099 and must be calculated by the investor or their tax advisor. Without the requisite information, one could mistakenly fail to disclose and report their sale of cryptocurrency.

Opportunities in the Current Environment

As the “crypto winter” has arrived, what can one do with any unrealized losses? Can one simply sell their entire portfolio at a loss to offset other gains?

Capital losses from the sale of cryptocurrency can be combined with losses from securities and a net loss of $3,000 can be deducted on an individual’s tax return. Any unused losses can be carried forward indefinitely. However, taxpayers should be aware of the wash sale rule. When you purchase a similar security within 30 days after selling it for a loss, the IRS does not allow you to realize that loss. However, the IRS defines cryptocurrency as property and not a security, which allows a taxpayer the opportunity to repurchase the cryptocurrency right after realizing a loss.

If you’re wondering if you can take a loss for NFTs, it would depend on how you dispose of your NFT. If you “burn” it, meaning you destroy the NFT, there might be a problem in trying to claim the loss because the asset did not transfer to another party. One would need to find a third party to effectuate an arms-length transaction in order to recognize any loss.

Planning for the Worst

There have been a number of crypto exchanges that went bankrupt in 2022, causing more frustration and confusion amongst taxpayers and advisors alike. What happens if your investment is stuck in one of these exchanges and you’re unable to retrieve your money? Can you deduct the loss? This is a question that there is currently no guidance on. Generally, one would need to actually dispose of the tokens within an exchange to claim a loss, but now many people’s investments are locked up, so disposing of them is not an option. Worthlessness “write offs” only apply to securities, so can we apply this concept to digital assets in light of previous guidance from the IRS treating digital assets as property instead of securities? This is another open item where additional guidance is needed from the IRS.

Conclusion

While the above are only some of the many questions left unanswered, there are planning strategies that can be implemented when it comes to cryptocurrency and your greater portfolio as they relate to your tax obligations. As these topics evolve and as questions are answered, we will continue to update you on the tax authorities’ positions and what can be done to best plan when clarifications arrive. For more information or to discuss planning for your specific circumstances, contact your Anchin Relationship Partner or Edward Kim, a Partner in Anchin’s Private Client Group, at [email protected].