Cryptocurrencies may not be all that new, but crypto taxes have become a hot topic. In 2020, the IRS added a question about virtual currencies on the top of Form 1040, which made it painfully obvious that taxpayers need to report their crypto holdings. It also left many taxpayers wondering if they need to amend prior returns to account for past crypto gains.
With about a quarter of Americans owning cryptocurrency, the greater awareness of crypto tax requirements has led to a growing number of questions for tax professionals. Accountants that don’t have experience with cryptocurrencies need to quickly get up-to-speed to help clients in accurately filing cryptocurrency taxes and minimize their tax liabilities.
Let’s take a look at some common questions and tax strategies for clients that own and transact in cryptocurrency.
Crypto Taxes 101 - Capital Gains and Losses
The IRS treats cryptocurrencies as property for tax purposes. Like stocks, bonds, and real estate, taxpayers incur a liability when they sell or trade cryptocurrency for a profit while writing off any capital losses. The tax rate depends on the taxpayer’s tax bracket and whether the transaction was a short- or long-term capital gain.
In addition to capital gains and losses, individuals that receive cryptocurrency as part of their business, mining activities, or employers must report it as income. If they sell the cryptocurrency for a profit, they are also responsible for paying capital gains taxes on any increase in value since it was acquired.
Cryptocurrency gains are reported on Form 8949 alongside other capital assets. Once complete, the net gain is transferred to Form 1040 Schedule D. A big challenge with this process is determining the cost basis of crypto-to-crypto transactions in U.S. dollars when completing Form 8949—particularly if there are a lot of transactions.
Cryptocurrency tax software, like ZenLedger for Tax Professionals, can help automate the process by integrating with clients’ wallets and exchanges, downloading their transactions, and automatically determining the cost basis and capital gain or loss. You can even auto-generate Form 8949 and Form 1040 Schedule D to simplify the process.
Virtual Currency Question on Form 1040
The IRS added a virtual currency question to the top of Form 1040 in 2020, which every single taxpayer must answer. While the same question appeared on Form 1040 Schedule 1 last year, not all Americans completed the Additional Income and Adjustments to Income form, which means that they may have missed the question last year.
In the Form 1040 instructions, the IRS indicates that taxpayers must check “Yes” if they “engaged in any transaction involving virtual currency”. The agency doesn’t provide an exhaustive list of virtual currency transactions, but in general, clients that deal with them—even in a remote sense—should answer “Yes” on the form.
As an example of edge cases, a client that uses the Brave web browser and receives Basic Attention Tokens (BAT) in exchange for viewing ads should answer “Yes” if they’ve transacted the tokens (e.g., converted them into Bitcoin or exchanged them for another good or service). Clients must also report crypto that they receive through things like hard forks or airdrops.
Clients that merely hold cryptocurrencies can safely answer “No” if they did not experience a taxable event during the tax year.
Types of Crypto Clients
Cryptocurrencies are a bit more complex than conventional financial assets. In addition to a capital asset, they can be used as transactional currencies or as part of financial services agreements. An easy way to get a handle on potential crypto tax implications is to group clients into different buckets based on the way that they use cryptocurrencies.
The most common types of crypto clients include:
- Active Traders: Active traders frequently buy and sell cryptocurrencies, which typically generate short-term capital gains. They may also participate in initial coin offerings (ICOs) or other speculative opportunities.
- Long-term Investors: Long-term investors buy and hold cryptocurrencies with a focus on Bitcoin. Alternatively, they may indirectly own cryptocurrencies through exchange-traded funds (ETFs) or other investment vehicles.
- DeFi Participants: DeFi participants lend cryptocurrency that they own via a growing network of DeFi platforms. In exchange for lending or providing liquidity, they may receive cash or crypto payments that are subject to taxes.
- Crypto Miners: Crypto miners earn cryptocurrency in exchange for completing computationally intensive tasks on the blockchain. If structured as a business, they may be able to write off computer hardware and electricity usage as expenses.
- Business Owners: Business owners may accept cryptocurrencies as a form of payment from their customers and either sell them immediately for U.S. dollars or hold them. They may also pay employees with cryptocurrencies.
- Consumers: Consumers may use cryptocurrencies to transact with friends or businesses or earn cryptocurrency from their employers. As of right now, currency-like transactions are still taxed as property and employees must claim crypto as income.
Most clients fall under the trader, investor, or consumer umbrellas. In each case, they are responsible for determining the cost basis and computing the capital gain or loss for each transaction. DeFi participants, crypto miners, and business owners represent more niche clients where different tax nuances may come into play—particularly with deductions.
Getting Up to Speed With Crypto
Tax professionals have a variety of different professional resources that can get them up-to-speed on current crypto laws and keep them abreast of any changes. In addition, many of these courses can help you earn CPE credits.
Some options to consider include:
- CPA Academy: Courses range from how to file the 1040s containing cryptocurrencies to new developments in reporting and enforcement.
- Wolters Kluwer: Course on cryptocurrencies and blockchain technology that goes into the fundamentals of how these systems operate.
- Miles Education: A certification program from the AICPA with 16 CPE credit hours that goes in-depth into blockchain technologies and their tax implications.
Of course, ZenLedger for Tax Professionals can help you eliminate a lot of the legwork associated with crypto clients and ensure that their taxes are accurate and up to date. The platform makes it easy to manage all of your clients in a single location and even provides tools like tax-loss harvesting to help them reduce their tax liability.
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Checklist of Ways to Help Clients Reduce Crypto Tax Liabilities
Use the following checklist to help clients reduce their crypto-related tax liability.
- Harvest Tax Losses: Tax loss harvesting strategies can help reduce tax liabilities in the current year. Unlike the equity markets, the Wash Sale Rule does not apply to crypto transactions, which creates far more opportunities.
- Be Selective with DeFi: Some DeFi platforms pay “interest” that’s taxed as ordinary income while others tokens (e.g., cTokens) that are taxed as “capital gains”. These differences can make a big impact on overall tax liability.
- Increase Holding Time: Long-term investors may be better off riding out volatility, rather than buying and selling, in order to avoid short-term capital gains tax. With a growing number of ETF options, they may also want to consider a diverse equity.
- Trade Crypto in an IRA: Crypto assets can be held in a Traditional or Roth IRA, which eliminates short-term capital gains taxes. Depending on the employer, crypto assets may also be held in a company-sponsored 401(k) plan.
- Consider Donations: Like other capital assets, cryptocurrencies can be donated in order to avoid paying capital gains taxes. Clients that have a large capacity for write-offs may want to donate crypto rather than stocks.
The Bottom Line
The IRS is stepping up its cryptocurrency tax enforcement with a front-and-center question on the 2020 Form 1040. With about a quarter of Americans holding cryptocurrencies, this has created a headache for many accountants that haven’t had to deal with cryptocurrencies to date. Fortunately, it’s easier than ever to get up to speed and streamline the tax process.
You can learn more about the benefits of ZenLedger's tax professional suite here.
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