Reporting Cryptocurrency Transactions while Minimizing the Tax by Lewis Taub, CPA
Posted on January 19, 2023
The IRS has new tools at its disposal to crack down on taxpayers who fail to report gains and losses from cryptocurrency transactions in 2023. In this environment, it is critical taxpayers understand their obligations to pay taxes on crypto transactions and look for potential opportunities to minimize those liabilities.
Cryptocurrency Tax Compliance
In 2014, the IRS announced it would treat cryptocurrency as property subject to tax in the same way it treats sales of stocks, bonds and other investments: gains on assets held for more than one year are taxed at a maximum rate of 23.8 percent, while gains on the sale of assets held for one year or less are taxed at a maximum rate of 37 percent. Yet, it wasn’t until 2020 that the IRS first addressed crypto assets on the annual 1040 income tax form, asking taxpayers if 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 a financial interest in a digital asset) during the tax year.
In recent years, the IRS also intensified its efforts to catch tax cheats by subpoenaing the customer lists of many cryptocurrency exchanges and identifying those individuals with cryptocurrency transactions of $20,000 over a period of years. Beginning in 2023, the IRS’s reach goes even further, requiring cryptocurrency exchanges to report investors’ transactions annually on IRS Form 1099. In addition, businesses that accept cryptocurrency payments of $10,000 or more in a single transaction will have to report those transactions to the IRS and include the payor’s name, address and social security number.
In light of these compliance enforcement efforts, taxpayers must look for opportunities to legally minimize the taxes on crypto transactions. The following are just five potential strategies to consider.
Properly Identify the Cost of Cryptocurrency and the Dates Bought and Sold
Generally, taxpayers can calculate their taxable gains on the sale of appreciated assets when they know the original cost they paid to acquire those assets (also known as their cost basis), the date of acquisition, and the date of sale. However, due to the very nature of cryptocurrency and the way it is acquired over time and traded on exchanges, investors often find it difficult to determine this information accurately. Keeping accurate cost basis information is important because the IRS allows investors to use specific identification accounting to track every crypto asset they buy and sell. When done properly, investors may be able to reduce both the gain on the sale of crypto assets and their related tax liabilities.
Consider an investor who acquired a collection of Bitcoin over time, for example, buying it once a year over five years when the prices were higher than today. On Dec. 1, 2022, when one Bitcoin was worth $17,500, the investor sold some of their coins and used the specific identification method to identify one or more of those purchases as the relevant price to calculate a loss. If the investor has a significant capital gain from the sale of other assets in 2022, it would be wise to “specifically identify” the Bitcoin sold to create a loss that they may use to offset that gain.
Take Advantage of a Tax Loophole on Losses from the Sale of Cryptocurrency
Because the IRS treats cryptocurrency as property and not as a security, it is exempt from the wash sales rules that prohibit taxpayers from selling stocks and bonds at a loss and rebuying them within 30 days simply to acquire a tax deduction. This means that a cryptocurrency investor may sell their Bitcoin at today’s depressed prices, creating a tax loss to offset taxable gains, and tomorrow turn around and repurchase those coins. Investors should be forewarned, however, that Congress has spent the past two years working to close this loophole and may finally get its way in 2023.
Minimizing the Tax on Zirdrops
Cryptocurrency developers often distribute new tokens to potential investors, sometimes for free, to garner attention and build a loyal base of users. However, investors should be aware that the IRS will treat these so-called “airdrops” as taxable income to the investor when he or she has “dominion and control” over the currency he or she receives. Therefore, individuals will owe tax on airdrops placed into their wallets, even if they did not ask for the tokens, or they received them free of charge.
While some developers make airdrops directly into investors’ wallets, others require recipients to claim the tokens by a specific date. This latter situation creates a tax-planning opportunity for investors to time their claims so that they neither have “dominion and control” of the cryptocurrency nor any resulting taxable income in a particular year. However, it is often a good strategy for investors to claim tokens in an airdrop as soon as they receive them, when the cryptocurrency has little or no value due to a lack of active trading. Getting the terms of an airdrop and the resulting tax implications can be tricky and often requires a consultation with a cryptocurrency tax expert.
Claim all Deductions Related to Mining
Mining cryptocurrency refers to the process of creating new coins and processing and confirming new transactions on the blockchain.
Crypto miners are required to pay taxes on the fair market value of coins they develop when they receive them. Mined cryptocurrency is taxed at an ordinary income tax rate that varies between 10 percent and 37 percent. Miners are also responsible for paying self-employment tax on mined income at a rate as high as 15.3 percent.
To minimize these taxes, miners may claim deductions for the business expenses they incur to create those coins, including the cost of computer equipment acquired and used solely for mining purposes, electricity, repairs, supplies and rent. Yet, it is important to note that the IRS may treat mining as a hobby rather than a business, especially when miners’ expenses exceed their income for several years.
Keep Accurate Records
One of the biggest cryptocurrency issues from a tax-reporting perspective is the lack of accurate books and records reflecting investors’ cryptocurrency transactions. The way investors obtain cryptocurrency and the dynamic and constant fluctuations in trading value often lead to a lack of accurate recordkeeping to reflect crypto purchases, tokens received in airdrops and even the period during which the investor held his or her coins. As a result, many users find themselves in need of forensic accounting assistance to track transactions and recreate records for many previous years.
Accurate records reflecting cost basis, dates acquired, dates sold are essential to be able to both ensure the proper and full reporting of crypto transactions and to implement strategies to minimize the tax on cryptocurrency transactions.
With the IRS’s increased vigilance to combat cryptocurrency tax evasion, it is vital that each investor report their transactions on annual returns after implementing the many strategies to minimize tax on cryptocurrency transactions.
About the Author: Lewis Taub, CPA, is a director of Tax Services in the New York office of Berkowitz Pollack Brant Advisors + CPAs, where he works with entrepreneurial businesses, multinational entities and multi-state corporations on tax planning and compliance strategies, including those related to mergers and acquisitions, basis issues and debt restructuring. He can be reached at the CPA firm’s New York office at (646) 213-7600 or firstname.lastname@example.org.