2022 has been a wild ride for digital assets. Bitcoin and Ethereum both dipped more than 70% from their late 2021 highs. However, the industry is still in its infancy and changing rapidly, and we’re seeing more proposed regulation than in any other year since bitcoin’s inception in 2009. Also, we witnessed a successful Ethereum Merge, changing from Proof-of-Work (PoW) to Proof-of-Stake (PoS), and the tokenization of assets continues to be a hot topic.
Below is a list of tax planning considerations for digital asset investors as we approach the end of 2022.
Change to Wording of Virtual Currency Question on 2022 Page 1 of 1040
On the 2021 Form 1040 U.S. Individual Income Tax Return, the IRS included a question on page one that asked, “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” On the recently released draft of the 2022 Form 1040, the IRS changed the question to: “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)?”
The new question clarifies that “receiving” means crypto earned by reward, award, or compensation; adds the term “gift”; and replaces the term “virtual currency” with “digital asset.” It appears that the IRS is trying to encompass all forms of digital assets beyond just cryptocurrency, such as non-fungible tokens. We should expect this question to continue to change over time as the digital asset industry matures.
Consistent with 2021, an individual who just buys and holds digital assets can still answer this question “No.” However, any additional activity—such as stacking, which has become increasingly popular—would require a “Yes.”
Wash Sale Applicability to Digital Assets & Tax-Loss Harvesting
A seemingly inescapable topic when discussing buying and selling digital assets is whether the traditional wash sale rules that apply to stocks or securities also apply to digital assets.
IRS Publication 550 states that: “A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical stock or securities,
- Acquire substantially identical stock or securities in a fully taxable trade,
- Acquire a contract or option to buy substantially identical stock or securities, or
- Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA.”
In other words, if you purchase a stock or security, sell the stock or security at a loss, and turn around and purchase that same stock or security within 30 days, the loss is limited. Since digital assets are classified as property for tax purposes, wash sale rules do not apply (as of tax year 2021).
With the traditional wash sale rules out of the way, taxpayers can take advantage of what is known as “tax-loss harvesting.” Tax-loss harvesting, put simply, is a strategy allowing taxpayers to sell their investments at a loss to offset other capital gains.
Let’s look at an example: Taxpayer A purchases one bitcoin for $60,000 in November 2021. As of September 2022, Taxpayer A is still holding their bitcoin. Taxpayer A decides to take advantage of the lack of wash sale rules for digital assets and sells their one bitcoin for $19,000. Taxpayer A now has a $41,000 loss to recognize on their tax return. Taxpayer A, immediately after selling their one bitcoin, repurchases one bitcoin for $19,000. Taxpayer A still has one bitcoin and also now has $41,000 in tax losses to report on their 2022 tax return. Had the wash sale rules applicable to stocks or securities applied to digital assets, Taxpayer A’s $41,000 loss would not be allowed.
Taxpayers should keep in mind the capital loss limitations and change in accounting method when determining the inventory valuation method.
Form 8938/FBAR 114 Filing Requirements
Currently, there is very little guidance on whether owners of digital assets, who have traded on foreign exchanges, need to file Form 8938 or Report of Foreign Bank and Financial Accounts (FBAR) 114.
FBARs are required to be filed by U.S. taxpayers that held $10,000 or more in one or more foreign bank accounts during the tax year. Currently, the FBAR regulations do not define a foreign account holding virtual currency as a type of reportable account. However, according to FinCEN Notice 2020-2, FinCEN intends to propose to amend the regulations regarding FBARs to include virtual currency as a type of reportable account under 31 CFR Section 1010.350.
Form 8938 is similar to the FBAR but has higher reporting thresholds and includes more types of foreign assets. For single and married filing separate filers, taxpayers should file Form 8938 if their foreign assets exceed $50,000 at the end of the year or more than $75,000 at any one time during the course of the year. These thresholds increase for married filing joint filers to $100,000 and $150,000, respectively. Please note that taxpayers living abroad have different filing thresholds. We are still waiting for the IRS to provide clear guidance on whether Form 8938 applies to digital assets held with foreign financial entities like cryptocurrency exchanges; however, a conservative approach would be to file Form 8938 in the absence of guidance.
Examples of Activities Reportable at Ordinary Income Rates
Accurately classifying the characters of gains and losses for digital assets can be tricky. One common misconception is that all digital asset activity is treated as a capital gain or loss. Some examples of common events that are reportable at ordinary income tax rates include, but are not limited to, cryptocurrency mining, staking rewards, airdrops, interest income, and earnings received from various platforms.
Mining
Cryptocurrency mining is an activity where computer resources are used to process complex equations to verify transactions on a blockchain ledger. By doing this, the taxpayer has a chance to receive cryptocurrency for performing this service (commonly referred to as rewards). The mining rewards are realized as ordinary income at the fair market value on the date of receipt. If you turn around and sell the rewards later, which results in a capital gain or loss, your cost basis will be the amount originally included in your ordinary income. The holding period to determine short-term or long-term treatment starts on the date you receive the mining reward.
Staking
Staking is an activity in which participants “lock up” a certain amount of their digital assets and actively participate in validating transactions on their respective blockchains. The reward received in most cases is derived as a percentage of network fees. Consistent with mining rewards and absent any further guidance, staking rewards are realized as ordinary income at the fair market value on the date of receipt.
For example, Bob stakes Ethereum (ETH) and earns $1,000 of ETH over time. Bob would recognize $1,000 of ordinary income on his tax return in the year received (to the extent that taxpayer has dominion and control). If Bob sells the ETH he earned as a reward six months later for $2,500, he will recognize $1,500 of capital gain.
($2,500 proceeds - $1,000 reward Bob paid ordinary tax rates on = $1,500 capital gain)
Staking rewards received but not accessible at the time of receipt are not taxable. They are only recognized as ordinary income when the reward is accessible (dominion and control) to the individual. Although there may be some uncertainty about whether staking rewards are deemed taxable, the conservative approach is to include them in ordinary income. A famous court case in the crypto community, Jarrett et al v. United States helped shed some light on what the IRS’ stance was on digital assets received via staking, and not mining. The taxpayers argued that staking rewards should not be includable in income until the time at which they are converted to dollars or another digital currency. It is worth noting that recent proposed legislation supports taxpayers' view on this matter. Jarrett et al v. United States nor the proposed legislation should be relied upon as the case was dismissed as moot since the IRS issued the refund sought by the taxpayers or until the case has reached a verdict or until the proposed legislation is signed into law.
Lending
Certain exchanges allow you to lend your crypto in exchange for “interest income,” which is taxable at ordinary rates. For example, cryptocurrency exchanges allow users to earn interest by lending their own crypto or even by opening a crypto savings account that offers a higher rate of return than traditional financial institutions. The interest earned will be treated similarly to interest you would expect to receive from a bank via Form 1099-INT. If you decide to take out a loan from these exchanges, any interest expense paid may be deductible depending on the use of the loan proceeds.
Airdrops/Hard Forks
If taxpayers receive an airdrop (not to be confused with iPhone’s® AirDrop® feature), the taxpayer is expected to recognize the fair market value of the digital asset received as ordinary income. Airdrops can be received from multiple sources, but most commonly from hard forks, bounties (performing tasks), and airdrops from the marketing of a project by their developers. If the airdrop is on a vesting schedule or is still locked at time of receipt, it is not included in taxable income until the taxpayer has dominion and control over the asset.
Rewards
Lastly, earnings from “decentralized finance” (DeFi) and blockchain-based gaming and learning platforms are taxable at ordinary rates. Some platforms allow taxpayers to earn crypto rewards by watching short videos to learn about different technologies on their website in exchange for cryptocurrency. One key phrase to keep in mind when determining the applicable income tax rates on digital asset activity is, “rewards are realized as ordinary income at the fair market value on the date of receipt.”
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Read more articles from the FORVIS' 2022 tax guide.