This is the third installment in a series on planning for cryptocurrency assets. The purpose of this series is not to debate the merits of cryptocurrency or provide commentary on its outlook. Instead, it’s meant to serve as a resource for those holding cryptocurrency and how to properly factor it into your financial plan.
While the world of cryptocurrency continues to develop, regulators are still playing catchup. One can no longer dismiss the tax implications of buying and selling these assets. Bitcoin and all other types of virtual currency are subject to taxes by the IRS — and those implications must be considered if you are selling material amounts.
Here are three key considerations you should keep in mind for the purposes of tax planning around virtual currency.
Disclose, Disclose, Disclose
If it wasn’t clear before how to report your gain or loss information from the sale of your cryptocurrency, the IRS is working to change that and put a stop to taxpayers’ ability to claim ignorance.
In 2019, the IRS added a yes/no checkbox to the 1040 Schedule 1 form to inquire into whether the taxpayer held, sold, or exchanged virtual currency during the year.
In 2020, this question was moved to the front page of the 1040. Needless to say, an asset that once existed in an ambiguous tax realm is now being addressed on Page 1 of the return.
If you had transactions related to virtual currency during the year, the first step is to make your CPA aware. Additionally, if you hold crypto at an online exchange and sold anything during the year, you will very likely receive a 1099 for the purpose of reporting a gain or loss.
It’s Property, Not Currency
From an IRS perspective, virtual currency is technically not currency — it’s property. This brings tax into the crypto conversation — anywhere from selling to mining crypto, to using it to pay for goods and services.
That means when you sell your cryptocurrency to cash, convert it to another cryptocurrency, or use it to pay for goods/services, a taxable event will occur. If you sell/exchange crypto that you’ve owned for less than a year, you will pay ordinary income tax on the difference between your purchase price and sale price. If the crypto is held for more than one year, you pay the more favorable capital gains tax rate on any gains. If the “event” is occurring at a price where the current value is less than the value when you acquired the crypto, you will not have a taxable gain.
The same logic applies to using cryptocurrency to purchase goods or services. Want to buy a pizza in Bitcoin? Be prepared to recognize a taxable event at the time it was exchanged for the pizza if the current price is greater than the price you originally acquired the currency at.
Lastly, this also means that you will owe tax on any cryptocurrency you received as payment. For example, if you acquired Bitcoin from mining activity, that “event” is taxable income to you upon receipt at its fair market value.
One last callout for those keeping their estate planning in mind: Because cryptocurrency is considered property (at the time this article was written) cryptocurrency held inside your estate in a taxable account (outside of an IRA/work retirement plan) will qualify for a step-up in basis at your death. By keeping this type of asset inside your estate at death, the cost basis of your crypto will be “stepped-up” to equal the fair market value on the date of your death. This would allow your heirs to sell their inherited crypto at a potentially reduced capital gain cost.
Watch Out for Tax-Loss Harvesting Opportunities
Perhaps the most notable difference in tax treatment for crypto at the time of this post is that there are currently no wash sale rules in place.
The wash sale rule says that if you plan to sell a stock/security at a loss and repurchase an identical position within 30 days, that tax loss is disallowed. Because of a quirk in which the tax code is written and how crypto is classified (as property, not a stock or security), wash sale rules do not apply.
Here is an example:
You own 1 BTC, which you purchased at $40,000 per coin. Let’s say a 15% drop in price occurs and your BTC is now only worth $34,000. If you sell your BTC holdings, you will receive $34,000 in cash and a $6,000 capital loss, which can be netted against other capital gains incurred during the year, or carried forward to future tax years. With the $34,000 in cash, you can reinvest that cash into BTC, or any other cryptocurrency so you are still “in the market,” should the price subsequently rise.
There are now several offerings in the marketplace that allow you to track the cost basis, purchase price, holding term, etc., of your cryptocurrency to better optimize your tax reporting and ability to tax loss harvest.
Planning for the purchase and sale of cryptocurrency is an important part of your overall tax strategy. Just because BTC doesn’t trade on the major exchanges, doesn’t mean the IRS isn’t looking for ways to collect their share. By keeping the above in mind and working closely with your tax and wealth advisor, you can make sure you are planning appropriately.
Specific details on tax reporting for those that mine crypto are beyond the scope of this article. Please reach out to Plancorp or your CPA for more details.
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Read Incorporating Crypto into An Existing Investment Allocation here.
Read Estate Planning for Cryptocurrency here.