Written by 1:51 pm Cryptocurrency

Cryptocurrency taxes in the wake of FTX’s meltdown

​​Financial advisors who disdain digital assets might think they’re far removed from cryptocurrencies, which have been rocked by the bankruptcy filings of the FTX exchange and BlockFi, a digital asset lender. In fact, all advisors are at least ankle-deep in the asset class, and they have the Internal Revenue Service to thank for that position: For the second straight year, the nation’s tax collector asks all American taxpayers a pointed question about their cryptocurrency holdings, right at the tippy top of their federal returns. 

On filings submitted this year, the query was “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” Come the filing season next April, the IRS’s question gets more pointed: “At any time during 2022, did you: (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)? (See instructions.)”

Taxpayers sign their returns under penalty of perjury, so coming clean is essential to avoiding penalties, interest and worse — as well as an opportunity for advisors to get to know some clients better.

“The most important thing for advisors with crypto is that question on the 1040,” said Lacey Shrum, a lawyer at Vela Wood in Dallas whose clients include registered investment advisory firms working with strategies for blockchain, the technology behind digital assets. “Clients are either saying ‘yes’ or ‘no’, and advisors at least need to know that piece.”

Read more: How financial advisors can protect clients and themselves from crypto risk

If bitcoin, ethereum and other digital currencies are on the IRS’ radar screen, they’re also occupying client mindshare. While crypto holdings for most individuals are relatively small — the median flow is less than one week’s worth of take-home pay — almost 15 percent of individuals conducted transfers into crypto accounts as of mid-2022, JPMorgan Chase said this month. Eight in 10 advisors report being asked about the asset class, but only 14% use or recommend cryptocurrencies. Just 7% have clients invested based on their recommendations. Still, nearly half of advisors, or 45%, expects to do so eventually as a result of client requests, according to a Cerulli Associates study last year. “For advisors, cryptocurrency is increasingly too impactful to ignore,” Cerulli wrote.

Read more: Surprise! Your clients already have crypto, and here’s what you need to do about it

Understanding the notoriously volatile asset class is hard — bitcoin peaked at $64,000 in November 2021 and is now around $17,000 — and making sense of its tax treatment is even tougher. Advisors talk about the need for tax-efficient investing with stocks, bonds and exchange-traded funds, so here are two core tax issues for cryptocurrencies:

The paper chase
Investors are required to report their crypto transactions to the IRS, which treats cryptocurrency as property, not as money, and taxes it like a stock. Taxpayers must disclose gains and losses, with profits on assets held for more than a year taxed at the long-term capital gains rate, now a top 23.8%, which includes the Affordable Care Act levy. The exceptions: When crypto is received as payment for goods or services, used to pay someone else or swapped for another currency, it’s taxed as ordinary income at ordinary rates, now a top 37%.

Investors with brokerage accounts holding stocks, bonds and funds go through this reporting ritual pretty much seamlessly every year. But figuring out profits and losses on crypto hinges on knowing what you originally paid, or your cost basis. For digital assets that have moved between exchanges and wallets or been airdropped as free currency into your wallet, that determination can be a nightmare. It’s even more tangled if foreign or decentralized exchanges, which avoid platforms and route trades directly between investors, or if “forks,” when the computer code underlying a coin splits into two, are involved.

When exchanges provide confusing documents, or none at all, things get tricky fast. “Sometimes just even figuring out what is taxable to you can be very difficult,” said Erin Finnimore, the head of tax and information reporting solutions at TaxBit, a tax and accounting firm in Draper, Utah, for digital assets. Companies like hers, CoinLedger and CoinTracking sell services that let investors import complex transaction data from their exchanges, but some investors are wary of the disclosure needed.

Brokerages like Schwab and Fidelity send customers a form each year that documents what they need to report to the IRS. But not all crypto exchanges do so; those that provide details do so through various incarnations of a broad form known as a 1099. The IRS gets a copy of each form sent.

Most exchanges send a 1099-MISC, for miscellaneous income, when an investor has more than $600 in transactions, according to CoinLedger. But the document typically discloses only interest income and money earned from referring customers to the exchange and from staking, which is when an investor uses his crypto stake to vouch for the accuracy of other transactions on the exchange. The form doesn’t disclose capital gains or losses. 

Read more: What the wealthy can fear from a new IRS rule on $600 payments

Some exchanges send a 1099-B, similar to a brokerage statement for stock trades that details cost basis, gross proceeds and capital gains and losses. BlockFi said in September that it would send the forms, but Kroll, which is overseeing the exchange’s Chapter 11 bankruptcy reorganization of somewhere between $1 billion and $10 billion of assets and liabilities, didn’t respond immediately to a query regarding whether the forms would go out. 

“I don’t think that 1099s are their priority right now,” Shrum said.

Starting next year, exchanges and payment networks such as Venmo must issue the forms if customers have at least $600 in cash or crypto transactions. The prior threshold was $20,000 across at least 200 transactions. While the 2021 law that created the requirement generally treats exchanges as brokerages, it’s unclear about who exactly is a broker and thus must provide the documents. Software developers, crypto wallet “suppliers” of storage services for digital assets and miners who verify and create new tokens could potentially be considered brokers, according to law firm Hanson Bridgett. Fennimore said that some industry players “don’t want to issue them until they’re actually obligated under the Internal Revenue Code.”

Some investors might receive a 1099-K, which shows the volume of all transactions with a given exchange, regardless of whether they’re taxable, but no details on gains and losses. 

“Unless you’re using a large-scale exchange or custodian, you’re on your own,” said Shrum.

Washed out
Cryptocurrency may be taxed like stocks, but it’s not subject to one big stricture that governs shares. The wash-sale rule, which requires a person to wait 30 days before or after selling a stock at a loss before repurchasing the same share or one “substantially identical,” doesn’t apply to cryptocurrencies, because the IRS doesn’t consider them “securities.”

That means some investors can sell their losing crypto, buy it back immediately when it rebounds, and use the loss to offset profits on other investments. The strategy is basically tax-loss harvesting — a staple with exchange-traded funds — that’s not subject to the wash-sale rule.

Read more: The risky side of tax-loss harvesting that advisors need to know

If the losses exceed the profits cashed in on other investments, an investor can use what’s left to reduce up to $3,000 of ordinary income a year and roll remaining amounts forward to lower taxes in the future. With short-term capital gains, on assets held for less than a year, equal to ordinary rates, an affluent investor in a high-tax state like California can avert a roughly 50% federal and state tax bill on a crypto sale, CoinDesk says.

Read more: What financial advisors need to know about crypto taxes this filing season

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