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It is estimated that about one in four Americans traded cryptocurrency (crypto) in 2021. Yet, finding a simplistic guide on the taxation of digital assets is seemingly impossible. This article is your new go-to resource for the federal tax implications of digital asset transactions (as of June 2022).    

“Virtual currency,” aka digital assets or cryptocurrency, is considered “property” according to the IRS. The tax treatment of virtual currency transactions is typically determined by how the taxpayer intends to use the digital asset. You can make a similar correlation between the treatment of security (stock) transactions and virtual currency transactions as security transactions fall under property treatment for tax purposes as well.  

In general, if a taxpayer sells or exchanges digital assets, a taxable event has occurred, and the character of the transaction will either be capital or ordinary in nature. However, there also are nontaxable events.    

There are four common nontaxable events related to digital assets:

  1. Purchasing and holding digital assets
  2. Transferring digital assets from one wallet to another (both wallets must be owned by the same party)
  3. Gifting digital assets is not a taxable event as long as the gift is under the annual exclusion ($16,000 for an individual in 2022)
  4. Donating crypto to a charitable organization (although you may be able to claim this as a tax deduction on your tax return)

The above events can generally be carried out without reporting income, gain, or loss. 

There are five common events that could cause a transaction to be taxable:

  1. Converting digital assets to fiat currency, e.g., U.S. dollars
  2. Converting a digital asset to another digital asset 
  3. Purchasing goods or services with digital assets 
  4. Receiving digital assets for compensation, a fork, or air drop
  5. Receiving mining, staking, or other DeFi rewards

Once a taxable event has occurred, the taxpayer must determine the character of the transaction. In general, the character will either be capital or ordinary. This will determine the applicable tax rates.  

2022 Capital Gains Tax Brackets

  For Unmarried Individuals, Taxable Income Over For Married Individuals Filing Joint Returns, Taxable Income Over For Heads of Households, Taxable Income Over
0% $0 $0 $0
15% $41,675 $83,350 $55,800
20% $459,750 $517,200 $488,500
Source: Internal Revenue Service

Converting Digital Assets to Fiat  

In most circumstances, this type of transaction will result in a capital gain or loss. This is the most common event related to digital assets and a simple formula should be used to determine a taxpayer’s gain or loss. The formula is as follows:

Proceeds – Cost Basis = Gain/Loss

Proceeds: Fair market value received less any transaction/gas fees
Cost Basis: Purchase price plus any acquisition costs, i.e., transaction fees

The gain or loss will be either short-term or long-term. If the taxpayer has held the digital asset for exactly one year or less, it will be a short-term capital gain or loss. If the digital asset has been held for more than one year, i.e., one year and a day, it will be treated as long-term. These gains or losses are then reported on Form 8949 and Schedule D of a taxpayer’s individual tax return.  

The “wash sale” rule disallows a taxpayer from claiming a loss on the sale and repurchase of identical securities within 30 days of the sale. This rule was implemented to prevent taxpayers from selling their securities at a loss (reducing their taxable income) and then immediately turning around and buying the same securities. Digital assets do not currently fall under the definition of “securities” according to wash sale rules. Therefore, one important fact to note on digital asset capital transactions is that wash sale rules currently do not apply. This can be a tax-savings strategy for taxpayers when investing in digital assets. However, the Build Back Better Act (The Act) did propose to subject digital assets to the wash sale rule. The Act was never passed, but it is likely we will see this proposal again.

Converting a Digital Asset to Another Digital Asset  

These transactions are treated the same as converting a digital asset to fiat as discussed above. The basis in your digital asset is the amount you spent to acquire the digital asset plus transaction, commission, gas fees, and other acquisition costs paid. The proceeds in your gain or loss calculation are equal to the fair market value of the digital asset sold at the time of the transaction.

Purchasing Goods & Services with Digital Assets  

If there is an increase or decrease in the fair market value from the time of acquisition of the digital asset to the time of payment utilization of the digital asset for goods or services, the paying taxpayer will recognize a capital gain or loss based on the increase or decrease of the fair market value of the digital asset used for payment.  

Receiving Digital Assets for Compensation, a Fork, or Air Drop  

When a taxpayer receives digital assets for compensation, they are considered ordinary income and will be taxed at the ordinary taxable income rates. Receiving digital assets for a good or service also may constitute ordinary income if the activity rises to the level of a trade or business. 

In blockchain terminology, a fork happens when the blockchain diverges due to a change in protocol. Similar to a fork in the road, a chain fork creates two side-by-side blockchains that originated from the same chain. Thus, if you owned the native token to the blockchain before the fork, you will now own the original native token and the new, forked token after the fork. When this occurs, if the recipient of the new token is deemed to have constructive receipt, they will report the fair market value as ordinary income at the point in time when they have dominion and control. 

Air drops are distributions of cryptocurrency coins, typically with the intention of promoting the use of the air-dropped coin. A digital asset received by air drop will generally be taxed as ordinary income.

Receiving Mining, Staking, or Other DeFi Rewards

Mining, also known as “proof-of-work” mining, is the process of validating cryptocurrency transactions that are subsequently added to the blockchain. Staking, also referred to as “proof of stake,” is the process of pledging cryptocurrency as collateral and, in return, a percentage-rate reward is earned. Mining rewards are taxed as ordinary income at the current year ordinary income rates. Mining cryptocurrency, according to IRS Notice 2014-21, may cause rise to business income and, therefore, trigger self-employment tax. If the activity rises to the level of a trade or business, despite being subject to self-employment tax, the taxpayer will be allowed to deduct any necessary and ordinary business expenses related to mining the cryptocurrency. 

Because IRS Notice 2014-21 specified mining and did not mention staking cryptocurrency, further guidance is needed for clarification on the tax treatment of staking income. However, given that staking is analogous to mining, a conservative approach would be to treat staking rewards as ordinary income. 

DeFi, short for decentralized finance, is a popular way to earn additional rewards through activities such as providing liquidity to liquidity pools and play-to-earn (P2E) games. Providing liquidity to liquidity pools allows decentralized exchanges to execute crypto-to-crypto trades without the capital typically provided by a centralized party. In return for providing liquidity, the liquidity provider is rewarded. P2E games are growing in popularity. In P2E, players earn rewards in the form of tokens as they play the games. Although no specific guidance from the IRS exists on DeFi activity, taxpayers are earning income through both liquidity mining and P2E gaming. Due to a lack of guidance from the IRS, a conservative approach would be to treat these rewards as ordinary income.

Ultimately, there has been limited guidance released by the IRS. IRS Notice 2014-21 and IRS Revenue Ruling 2019-24 are about the only authoritative guidance the IRS has issued to date. The IRS also has published a nonauthoritative FAQ page on its website. 

On March 9, 2022, President Biden signed an executive order calling for a responsible development of digital assets to protect consumers and ensure financial stability with the increasing popularity of digital assets. As digital assets continue to grow in popularity, further guidance and clarification from not only the IRS, but the government and regulators alike, is sure to come.

Contact a professional at FORVIS or submit the Contact Us form below if you have questions.   

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