As the use of virtual currency increases, so do the tax implications. In this article we will share a brief overview of some of the terms used in relation to virtual currency and non-fungible tokens (NFTs), as well as outline areas that may impact your taxes.
Defining virtual currency:
According to the IRS, “virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like “real” currency (i.e. the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance), but it does not have legal tender status in the U.S. Cryptocurrency is a type of virtual currency that utilizes cryptography to validate and secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.”
The IRS goes on to say: “Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.”
General tax implications:
Simply purchasing virtual currency is not a taxable event. The 2021 Form 1040 asked: At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?
Exchanging virtual currency for other property:
A gain or loss will be recognized if you exchange virtual currency held as a capital asset for other property, whether it is for other goods or other virtual currency. The gain or loss is based on the difference between the fair market value as of the date and time of the sale and the taxpayer’s basis in the sold assets, unlike when U.S. dollars are used to purchase or sell an item.
Loaning or taking a loan against your virtual currency:
If you loan your virtual currency to an organization and receive a token in exchange, this needs to be reported on your tax return. Taxpayers may choose to take a loan against their own virtual currency to acquire cash, rather than sell it, and this too creates another taxable event or loss from potential future earnings.
Reporting virtual currency in foreign accounts:
Currently the IRS is not requiring the reporting of virtual currency held in a foreign bank account on Form 8938. Many believe it is just a matter of time before this will change.
Mining:
This involves expensive data processing assets and use of electricity to solve complex mathematical problems on the blockchain that earn virtual currency. In IRS Notice 2014-21, mining income is considered earned income and is subject to both income tax and self-employment taxes.
Staking:
The staking method requires cryptocurrency holders to 'stake' or loan your cryptocurrency assets as collateral to support the operations of a blockchain network for a fixed period of time where it cannot be withdrawn. The depositor earns rewards for staking their currency. Staking evolved as a low-cost alternative to mining.
How are mining and staking reported on my taxes?
Although many of the tax implications for mining and staking aren’t clear, reporting these activities as self-employment income is the most conservative approach at this time.
Cryptocurrencies in retirement accounts:
An advisory issued by the Department of Labor regarding cryptocurrency investment options available in retirement funds indicated that cryptocurrency investing is speculative and volatile and has risk issues involving fraud, theft, and loss. They will ask fiduciaries of 401(k)s and other workplace retirement plans governed by the federal pension laws to demonstrate how this type of investment option meets the rrequired duties of prudence and loyalty.
Non-fungible tokens (NFTs):
NFTs are defined as unique cryptographic tokens (colored coins) that exist on the blockchain and cannot be replicated. They are a small fraction of cryptocurrency coin. They can be publicly traded and easily sold. They can represent digital assets such as digital art, music, videos, or can be used trade ownership of real-world items like artwork and real estate.
Even more so than virtual currency, the IRS has not issued guidance for NFTs. However, some general tax principles may be applicable. A tax “event” is normally not created until an item is sold, and then the creator should include it on Schedule C as income. On the other hand, if the purchase was made directly from the creator and not through a platform, the purchaser may have to issue a 1099.
Creators of NFTs may receive “airdrops” of free NFTs, which are considered ordinary income and taxed at fair market values. This income should be reported on the taxpayer’s 1040 in the year it was received. NFT creators may also win prizes which are subject to ordinary income tax for the value of the prize.
Other tax events may occur when NFTs are sold for a gain or a loss. Whether this is considered a capital gain (loss), ordinary income, or a collectible item will depend on what type of asset is being sold and the length of time the seller owned the digital asset. If cryptocurrency is used for the purchase, this may also create a gain or a loss that will have tax implications.
In addition, there are tax implications for NFT traders, and as well as for cryptogamers. If you are purchasing or selling cryptocurrency or NFTs, please note that the tax implications continue to evolve. Contact us if you have any questions regarding this area, and we will be happy to assist you with the tax information currently available.