Tax season is upon us. This means different things for taxpayers and tax authorities as it relates to activities involving digital assets (“crypto”).
Taxpayers who partook in the 2021 crypto bull market may need to pay hefty tax bills in the coming days, resolve some tax uncertainty on select transaction types, and/or take advantage of some remaining 2022 strategies that can reduce their 2021 tax bills.
The IRS will begin to piece together some of the Form 1099 data they will be receiving as exchanges increasingly report transactions involving crypto. Reporting by exchanges, however, will be patchwork based on the number and type of exchanges that report, and based on what data is reported. The IRS will need to make sense of the data; consider how to use it in crafting a balanced and tiered outreach / audit strategy; and assess how the information it receives influences the regulations drafting process for the reporting provisions of the Infrastructure Investment and Jobs Act and the suggestions it makes to the OECD on its anticipated framework for countries to collect and share crypto trading data.
More on these and other points is below.
Actions for taxpayers
Pay > 90% of 2021 taxes owed by January 18, 2022
Many taxpayers investing in crypto recognized significant gains in 2021:
- More than 68 crypto assets increased by at least 1,000%
- The two largest crypto assets by market cap, Bitcoin and Ether, posted gains that dwarfed most stocks
- Strategies involving the purchase and sale of NFTs on the secondary market produced a profit the majority of the time
Taxpayers who rode these waves with timely cashouts may face material tax bills. Even though 2021 tax returns of individuals are due April 18, 2022 (absent an extension), individuals will be required to pay (by withholding and/or estimated tax payments) at least 90% of their 2021 taxes by January 18, 2022 (with any remaining shortfall due by April 18, 2022).
Failing to do this can give rise to a tax penalty based on the amount of the shortfall. There is a safe harbor if the tax payments during 2021 are at least equal to the tax shown on one’s 2020 tax return (or 110% of this amount for “higher income taxpayers”).
Meeting these tax obligations may, in turn, create more crypto-related transactions to the extent taxpayers didn’t take advantage of year-end planning, such as “loss harvesting” and Opportunity Zone Fund investments. Below is more information on these types of funds.
File a tax return where guidance on certain transactions is unclear
When filing their tax returns in 2022, taxpayers need to get to the point that they can affirm under “penalties of perjury” that to the “best of their knowledge and belief” that their tax return is “true, correct, and complete.”
When it comes to some transactions involving crypto, this standard can have a heavier weight than for traditional income streams. Why?
Tax consequences involving traditional income streams, such as income from wages and selling stocks and bonds, are fairly well understood. Transactions involving crypto are far more diverse and nuanced, and often do not fit neatly into the lanes carved out for existing transactions. Further, crypto transactions often involve participants who are not accustomed to paying thousands of dollars to a tax professional to understand the tax consequences of a single transaction. Such issues may include:
- Whether “wrapping” bitcoin or other cryptocurrencies in another crypto asset or smart contract is taxable;
- How and when to tax activity from providing liquidity on a decentralized exchange (and does the answer differ based on the exchange);
- Whether and when NFTs are taxable at rates that differ from other crypto (capital) assets;
- Distinguishing between different types of crypto dispositions for purposes of determining which may be capital or ordinary in character; and
- When taxpayers are treated as engaged in a trade or business as a result of the direct or indirect participation in a consensus mechanism for a blockchain protocol.
The list of issues that engender deeper tax thought is much longer than this, and grows as the ecosystem innovates.
Consider leveraging tax software for cryptocurrency
The IRS published guidance on some crypto tax issues. Additional guidance that does not have the weight of the IRS behind it can be found on some of the websites of companies which make software products for calculating taxable income from transactions involving crypto. That said, these analyses are not always comprehensive or consistent, and the specifics of a particular transaction can easily change answers.
Separately, different crypto tax software products can produce different results on the same data set. The IRS and many taxpayers are aware of this, and some of the potential contributing factors include:
- Different ways to value transactions where fiat currency is not involved (e.g., crypto to crypto trades or the payment of fees in crypto);
- Methods for tracking basis of crypto moved through wallets;
- Determination of tax lots on an exchange-by-exchange basis or aggregating all of a taxpayer’s holdings (across exchanges);
- Segregating taxable dispositions into different categories where the tax treatment can differ (e.g., slashing, gifts, related party transfers, personal transactions, participation in DAOs);
- Treatment of acquisition, disposition, and withdrawal fees;
- Addressing the impact of derivatives on otherwise generally applicable rules; and
- Switching between different crypto tax calculation platforms where a prior tool may have treated different tax lots as sold than is accounted for in the new software product.
Explore 2022 actions for managing 2021 tax liability
Even though 2021 is behind us, taxpayers can employ some limited measures in 2022 to manage 2021 taxes due.
One includes investing proceeds from the sale of capital assets (including crypto) in an Opportunity Zone Fund within 180 days of the sale. At the time of this writing, this 180 day period reaches deep into 2021.
Such an investment offers three benefits on qualifying investments:
- Reduction of taxes on capital gains owed by 10%;
- Deferral of tax on current taxes owed on capital gains until December 31, 2026 (at the latest); and
- Tax-free appreciation on the new investment if it is held for at least 10 years.
The first benefit expired on January 1, 2022, but the latter two are still available.
Historically, most Opportunity Zone investments have been real estate related. However, some crypto – focused Opportunity Zone Funds recently launched with crypto mining and metaverse / Web 3.0 / crypto focuses. These types of investments, along with Roth IRAs and 529 plans are effectively one of the few congressionally – sanctioned means of earning tax-free asset appreciation – even on certain crypto (when structured properly).
Tax lot selection
Although not technically a measure that a taxpayer selects in 2022 to manage 2021 tax liability, it’s worthwhile to mention tax lot selection. If a taxpayer bought a crypto asset at different points in time at different prices, under IRS guidance a taxpayer is able to select the crypto asset (tax lot) they sold on a given date in 2021. Generally, this identification should be made at or before the time of sale. Exchanges on which crypto is sold typically do not have this functionality (nor have they been required to).
Thus, taxpayers would need their own pre-existing or contemporaneous documentation reflecting the tax lot selected at the time of the sale. If they have not made such timely identifications for their crypto dispositions, then the IRS’s view is that a first-in, first out method applies to determine which tax lots are sold.
I raise this point as many use software platforms for calculating 2021 taxes on crypto, and those platforms may offer the HIFO (“highest in, first out”) method for determining tax lots.
Declaring crypto transactions
Since 2019, the IRS has been asking on tax returns whether an individual has received, sold, exchanged, or otherwise acquired crypto during the year for which the tax return is filed. Presumably the vast majority of taxpayers answer this question truthfully given the penalties of perjury consequences mentioned above. What taxpayers don’t have to answer directly on the tax return is whether they ever sold or acquired crypto and didn’t report it. Although there is no legal obligation to file an amended tax return to correct prior errors or underreporting, failure to align prior acquisitions and dispositions can affect tax lot selection in the current and future years. It may also affect the IRS’s views on the appropriateness of an understatement penalty.
Actions for Government
Tax season for the government means a number of things.
First, it must process tax returns and align amounts declared on tax returns with third-party information reporting (e.g., Form 1099 (series), W-2s, etc.). Not surprisingly, analyses are automated and notices are generated where there is a mismatch between taxpayer reporting and third-party reporting (“CP 2000 Notices”). Historically, this process has not meant much for crypto, as there was little meaningful reporting for crypto transactions. Increasingly, that is changing with more domestic exchanges issuing different types of Form 1099s.
CP 2000 Notices are separate from the letter campaigns the IRS has employed in the past after learning from John Doe summonses data the taxpayer may have underreported. The IRS has announced that it will continue and expand these types of summonses which permit it to request trade data from a domestic exchange where it has reason to believe there is a group of individuals who may not be meeting their tax obligations – without having to name a particular individual.
The IRS has to balance its taxpayer audit activity with publishing guidance that reduces uncertainty and the potential for controversy. Aside from information reporting regulations applicable to exchanges, Treasury and the IRS have committed to issuing more guidance on crypto transactions. From the 2021 – 2022 Priority Guidance Plan, it is unclear what issues the IRS will take on (aside from the regulations relating to information reporting). That said, given the speed of innovation and advancement in the ecosystem, it is unlikely that the pace of published tax guidance can keep up.
This should not be understood to imply that the tax consequences of the vast majority of crypto transactions is uncertain. Selling crypto for cash is taxable, and aside from certain transactions like wrapping one crypto asset in another, crypto to crypto exchanges are generally taxable. The uncertainty comes from developments of the ecosystem involving new types of crypto assets, new types of entities (e.g., DAOs), new ways to support consensus mechanisms, new ways to transact, and new modes of doing business in Web 3.0.