Cryptocurrency Investors Need to Focus on Tax Issues Before Year-End

The year 2022 has not been good for cryptocurrency (virtual currency) investors. Bitcoin has been down more than 60 percent during 2022, and the offshore exchange FTX collapsed in November. The run-up in cryptocurrency over the last few years is a long distant memory.

Many federal employees who have invested in the cryptocurrency market in recent years would like to forget about their digital asset investments, at least for the short term until things may improve. But the IRS in not losing interest in cryptocurrencies. Cryptocurrency holders are highly encouraged at this time to focus on some of the tax issues associated with cryptocurrency investing. To understand why, it is important to first present some background information on virtual currencies and past IRS guidance on the tax treatment on virtual currency.

Definition of Virtual Currency

There are different definitions of virtual currency. Among the most common definitions:

(1) Virtual currency is any monetary asset in digital form, including digital forms of government currency;

(2) Virtual currency is a type of digital currency but is often unregulated; and

(3) Virtual currency is any currency that uses cryptographic technology to ensure the security of the transactions and control of the creation of new units, which include Facebook’s Libra currency.

IRS Guidance on Virtual Currencies

The first formal guidance that was issued by the IRS regarding virtual currencies was IRS Notice 2014-21. In that notice, the IRS defined convertible virtual currency as property, as opposed to currency. As such, the IRS explained that the acquisition of a virtual currency is the same tax-wise as the acquisition of any type of property, for example, land.

When an individual purchases, receives for services or goods, or mines virtual currency, its fair market value at the time of acquisition, plus any costs of acquiring the currency constitutes the cost basis in the currency. Most virtual currencies have exchange values in which the purchaser of the currency converts it into US dollars. That becomes the purchaser holder’s cost basis in the currency.

When the virtual currency is sold, exchanged, used to purchase goods or services, or is otherwise converted, the fair market value of the currency on the date of disposition becomes its selling price. The sale or exchange of virtual currency must be reported on a tax return. The holding period of the currency is determined as short or long depending on how long the currency has been in the possession of the holder.

The following is some information to help cryptocurrency investors make some cryptocurrency “moves” between now and December 31 and get prepared for expanded and new IRS scrutiny:

1. Use cryptocurrency losses as a means of reducing one’s tax liability.

There is somewhat of a silver lining for cryptocurrency holders whose holdings are held in taxable accounts rather than in tax-sheltered accounts such as IRAs. If a cryptocurrency investor sells his or her holdings and books a capital loss, then the loss can be used to offset current capital gains or future capital gains on capital assets sold at a gain. The gains do not have to associated with sales on digital assets; they could be stocks, real estate, mutual funds, ETFs, or other investments.

If a cryptocurrency investor with capital losses has no existing capital gains to shelter, then the losses can offset up to $3,000 of ordinary income such as salary, interest or pension income per year. The losses do not expire.

The following example illustrates:

Peter has a $35,000 realized loss in his cryptocurrency holdings as of December 9, 2022. If he sells his holdings, then he has recognized losses of $35,000. Because has no capital gains in his portfolio during 2022, he can reduce his wages by $3,000 for 2022. He can do the same in 2023. If during 2024 Peter incurs $15,000 worth of capital gains, then he can apply $15,000 of the remaining $29,000 in capital losses to apply against the capital gains. The $14,000 remining in capital losses are then carried to the year 2025 and beyond.

It is important to explain that the “wash-sale” rules do not apply to sale of cryptocurrency holdings. This means that a cryptocurrency holder could sell his or her holdings at a capital loss and then can immediately buy back the identical cryptocurrency holding, which is depressed in price. This action will not result in an IRS denial of loss due to violation of the “wash rules”. The “wash sale” rules do apply to other capital assets such as stocks, bonds, and mutual funds.

2. IRS reporting rules for brokers.

The 2021 Infrastructure Investment and Jobs Act included a provision requiring crypto brokers to report customer sale proceeds to the IRS on a 1099 form if the crypto account is held in a taxable (non-retirement) account. This reporting requirement is identical to what brokerage firms due for investors with stock, bond and mutual fund sales.

The purpose of the cryptocurrency reporting requirement by crypto brokers is to clamp down on many crypto investors’ tax avoidance. Until this law change, few cryptocurrency transactions were being reported to the IRS.

The new law is set to take effect January 1, 2023, with the first 1099 forms going to individuals in early 2024. Some tax specialists say that the reporting rule date may be postponed because the Treasury Department has to issue regulation including the definition of a cryptocurrency broker.

3. New court-ordered searches for cryptocurrency tax cheats.

A few months ago, federal judges approved two summonses requiring a cryptocurrency exchange and a bank to turn over customer information to the IRS to help uncover possible tax law violations associated with cryptocurrency.

In particular, the banks and the exchange were required to turn over the IRS customers who had $20,000 or more of cryptocurrency transactions in any one year from January 1, 2006 to December 31, 2021. The purpose of the IRS’s obtaining this information was to detect unreported income. Using this “summons strategy”, the IRS has assessed more than $110 million in tax due on unreported cryptocurrency income, and more is expected.

The IRS’ aggressive recent and continued pursuit of cryptocurrency investors who do not report their income should be a reminder to all cryptocurrency investors to get prepared for the new and more aggressive reporting cryptocurrency reporting rules. They are strongly advised to keep and maintain a full ledger of cryptocurrency transactions.