The old saw about taxes being one of life’s two certainties is only partially true for crypto investors in the United States.
This article is part of CoinDesk’s Tax Week series.
While there’s little argument that gains and losses associated with cryptocurrency transactions are taxable, there is little certainty about which taxes apply to different kinds of transactions and when.
Rob Garver is a longtime Washington, D.C., journalist who has written for American Banker, the Fiscal Times, Voice of America and ProPublica.
While some U.S. regulators, such as the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) and the Securities and Exchange Commission (SEC), have tried to be proactive in providing guidance to the industry about how they plan to treat crypto assets, the Internal Revenue Service has, so far, offered relatively little guidance on some of the most pressing issues facing investors and traders.
“Tax policy is, by far, the area of U.S. policy that's the furthest behind, as far as having sensible, easy-to-follow rules for people in the space,” said Peter Van Valkenburgh, director of research at industry lobbying group Coin Center. “We saw much earlier guidance from FinCEN on anti-money laundering policy, much earlier guidance from the SEC on [initial coin offerings]. The IRS, when it has issued guidance, it has been perennially late. And that guidance has generally been more confusing than helpful.”
The IRS did not respond to a request for comment for this story.
Kristin Smith, the executive director of the Blockchain Association, put it a tad more diplomatically.
“This is a very fast-moving space, and the IRS and Treasury Department have been trying to wrap their heads around it,” she said.
The agency was actually ahead of other regulators when, in 2014, it offered guidance that classified “convertible virtual currency” (the Beltway term for what most people call “crypto”) as property. However, progress has stalled since then, and the issues have begun piling up.
Smith said the industry generally thinks the IRS is operating in good faith, if more slowly than most would prefer.
“These are obviously people that don't have deep crypto backgrounds,” she said. “But I think they've taken a lot of effort to try to understand this space.”
Read More: US Crypto Tax Guide 2022
Congress gets involved in taxing crypto
If the IRS is moving slowly out of an abundance of caution (or, at worst, bureaucratic inertia), that may be preferable to the alternative, as evidenced by what happened when members of Congress pushed crypto-related language into the bipartisan infrastructure bill that became law in November.
In an effort to bring in more tax revenue from crypto traders, lawmakers created a requirement that cryptocurrency “brokers” report their clients’ trading activity to the IRS. Unfortunately, the legislative language was drafted quickly and with little input from the industry, leading to a definition of broker that is so broad that industry representatives warn it could encompass wallet software developers and even cryptocurrency miners.
The Treasury Department will have to draft implementing regulations before the law goes into effect in 2024, and in doing so it could narrow the range of entities that qualify as a broker. In a letter to lawmakers made public Feb. 11, the agency appeared to signal that crypto miners and stakers, at least, will not be considered brokers under the pending rule.
“I don't think that the intention of the law and the IRS is to capture miners, for example, or stakers,” said Omri Marian, a professor of law and the academic director of the Graduate Tax Program at the University of California, Irvine School of Law.
However, he said, it would be a useful sign of “goodwill” for the IRS to reach out to the crypto community during the rulemaking process. “I think that mostly what is needed there is to lower the tension a bit and explain who is and isn't the broker for reporting purposes.”
Some members of Congress have signaled they understand the industry’s concerns and are open to passing new legislation that would limit the definition of broker to an actual cryptocurrency exchange that facilitates transactions. However, given the deep divisions in Congress, it is unclear what the chances really are of such a bill passing.
Wait, crypto is cash now?
The same infrastructure bill that created the broker reporting requirement added another twist to the government’s tax treatment of cryptocurrencies. After years of being told their bitcoin and ether are property and not currency, the new law created an exception.
Under existing law, any person engaged in “trade or business” who receives $10,000 or more in cash in exchange for goods or services is obligated to report that transaction. The report, which includes identifying information about the individual who made the payment, goes to the IRS and FinCEN. The new law classifies cryptocurrencies as cash for purposes of that reporting requirement.
Because of the way the law is drafted, reports on crypto transactions of more than $10,000 would only need to go to the IRS, but that hasn’t made industry participants any less concerned about the effect it could have on some sectors of the crypto space.
The problem is that, in many cases, cryptocurrency transactions are functionally anonymous, meaning the individual on the receiving end of a transaction may not have access to the kinds of personal identifiable information about the sender the IRS wants to collect (or vice versa).
Additionally, many crypto transactions take place under circumstances that make it very difficult to assess who would be responsible for reporting. If a smart contract running on a decentralized exchange accepts $10,000 worth of bitcoin, who would file that report?
The cup of coffee exemption
One of the perennial frustrations of people who would like to use cryptocurrencies as a medium of exchange is the tax treatment of virtual currency as property means that virtually every transaction, no matter how small, amounts to a taxable event.
When someone holding bitcoin uses it to make a purchase, the IRS views the transfer of bitcoin from the buyer to the seller as the disposition of an investment, triggering capital gains taxes. Even the mining fees incurred when transferring bitcoin between two wallets held by the same individual are, technically, taxable.
Some, like Kirk Phillips, a certified public accountant and managing director of Global Crypto Advisors, say the administrative burden of tracking even the tiniest of transactions are standing in the way of cryptocurrencies becoming a more widely used medium of exchange.
“There are definitely people who have changed their behavior based on how it ends up getting taxed and having to go through the compliance gauntlet,” he said. “It's a major headache.”
There is a bill before Congress that would create what's known as a de minimis exemption for small transactions. The Virtual Currency Tax Fairness Act, sponsored by Rep. Suzan Delbene of Washington state, a Democrat, would exempt from capital gains taxes all crypto transactions in which the capital gain realized is under $200.
However, despite the fact the bill has broad support in the crypto community and has bipartisan backing in the House of Representatives, its chances of enactment are unclear. This is the third Congress in which the bill has been introduced and, to date, there is no similar legislation pending in the Senate,
Taxation and staking rewards
One of the more pressing issues facing the industry, given the increasing preference for proof-of-stake mining, is how staking rewards ought to be taxed.
The basic question is whether the cryptocurrency that a validator receives as a reward for appending a block to a proof-of-stake blockchain is taxable as income when it is received, or whether there is no taxable event until the validator disposes of the currency.
In a lawsuit filed in Tennessee, Joshua and Jessica Jarrett, a couple who run a validator on the Tezos blockchain, sued the IRS over taxes paid on staking rewards earned in 2019. The Jarretts argued that his receipt of the rewards ought not to have been considered a taxable event.
Rather than fight the case in court, the IRS offered, early this month, to refund the taxes the couple had paid, though without offering any clarity on how it would treat staking rewards in the future. The Jarretts rejected the offer, in a move aimed at forcing the courts to resolve the question of how to treat staking rewards.
The resulting situation is representative of much of the tax treatment of crypto transactions. In the absence of clear rules from the IRS, individuals are having to make their best guesses about how they think the agency will treat different transactions.
“I am only dealing with a limited number of taxpayers, but I don't know of anybody that's actually withholding on staking rewards,” said Lisa Zarlenga, a partner in the Washington office of the law firm Steptoe & Johnson. “If the IRS’ position is that they should be subject to withholding, I don't think it's happening.”
She said that, in general, taxpayers she works with are making a good faith effort to comply with tax laws by reporting income, when they believe it makes sense to report it.
“This could all hit the fan if the IRS starts auditing these transactions and taking positions that are different from what taxpayers are taking,” she said. “Then it could have a stifling effect.”
However, she said that as a practical matter it seems unlikely the IRS would implement some sort of retroactive crackdown that would penalize people who report income in a way the agency subsequently determined to be incorrect.
“I would be surprised if they started imposing penalties on people because they didn't comply, because there were no rules to comply with,” she said. “What they're more concerned about are non-reporters, people who aren't reporting their income from crypto transactions at all.”
Read More: Your Staking Rewards Are Still Taxable
Below the radar
While there may not be much clarity on the tax treatment of staking rewards, at least the crypto community can feel confident the issue is on the IRS’ radar. The same can’t be said for multiple other issues.
While new collectors may be content, for the time being, to stare at their digital galleries of Bored Apes and Hashmasks, eventually many are going to want to sell their NFTs. When that happens, how the IRS will treat any profit they realize is an open question.
Regular long-term capital gains taxes in the U.S., which apply to the sale of investments held for more than one year, max out at 20%. But there is a special carve-out for property classified as “collectibles,” a category that includes fine art, that tops out at 28%.
To date, the IRS has been silent on the question of whether NFTs ought to be treated as collectibles, creating the disconcerting possibility that the question of whether NFTs constitute real art might be determined in tax court.
Another area where existing rules are creating confusion is around the tax status of individuals who trade cryptocurrencies for a living. Under the law, an individual who buys and sells stocks and securities can claim “trader status” when they file their taxes, allowing them to deduct business expenses from their trading gains, and offering a number of other benefits.
The problem, said Shehan Chandrasekera, head of tax strategy at Cointracker.io, a portfolio and tax management service, is the statutory language appears to limit trader status to individuals who sell stocks and securities – not property, as crypto is classified.
“For people who are legitimately day-trading cryptocurrencies, the question is whether they should rely on those code sections that are written for stocks and securities to get those tax benefits,” he said. “Because if you can get that trader status, that's going to save you so much money in taxes. They struggle because it's only applicable to stocks and securities, but at the same time, it's unfair for them to not get that treatment, because they're actual traders of cryptocurrencies.”
This neither-here-nor-there status for crypto traders is analogous to the tax treatment of crypto assets more broadly. It’s a situation that frustrates advocates pushing for more clarity from the government, especially because it contributes to the impression the crypto space is a sort of Wild West, where the normal rules don’t apply.
“There's this myth that ‘crypto people just don't want to pay taxes,’” Coin Center’s Van Valkenburgh said. “I think the vast majority of people in crypto, just like the vast majority of Americans, just want clear rules to know what their tax obligations are so that every April isn't a nightmare. Then they'd be happy – as happy as anyone ever is – to pay their taxes.”
Further Reading on CoinDesk's Tax Week
Crypto won’t save you from taxes, but it may eventually make them easier to pay, says futurist Dan Jeffries.
Investors in MicroStrategy, Tesla, Block and Coinbase need to consider how wild price swings will affect results, not only directly but indirectly due to complex tax accounting rules.
To offset the impact of rising inflation, the IRS has revised a number of tax provisions to let people keep more of their money in their wallets for the 2022 tax year.
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