Crypto trading? Here’s What You Need to Know at Tax Time.

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Taxpayers who trade cryptocurrencies or other digital assets had a wild ride last year, and that doesn’t stop when it comes to tax time.

Cryptocurrencies like Bitcoin and Ethereum see-sawed wildly in 2021 as many investors moved in and out of the currencies, effectively day-trading them. Now the IRS expects gains, losses and income to be reported on individuals’ 2021 tax returns and is flexing its enforcement muscle to collect its due.

“This will be very challenging, because there are still a lot of unanswered questions about the tax treatment of certain digital assets,” says John Buhl, an analyst at the Urban-Brookings Tax Policy Center. These include what tax rate applies to gains on NFTs and whether interest income from a practice called staking should be taxed at all. What’s more, “taxpayers have to fully track everything, all of their transactions,” Buhl notes.

A critical missing resource for investors to do this efficiently is the Form 1099-B, which neatly sums up the year’s gains and losses for investors. Brokers are required to issue these reports each year to investors holding stocks, bonds and traditional investments. Crypto investors don’t get this form, largely because exchanges don’t yet have the systems in place to track the transactions and aren’t required to do so. So investors have to figure profits and losses out on their own to accurately file taxes.

The $1 trillion infrastructure bill, which passed in November, requires that starting next year exchanges that allow investors to buy and trade crypto issue reports to both taxpayers and the IRS. This will help not only with taxpayer accounting but with IRS enforcement. For now, taxpayers are largely on their own to retrace their trades and calculate their gains or losses.

Taxpayers trading digital assets through large exchanges such as Coinbase and Kraken can access some information about their trading history and cost basis, which is the value of an asset at the time of its purchase, and essential to calculating gains and losses. But the platforms don’t distribute reports summing up gains or losses.

“Some information you get can be hard to interpret. Depending on how many transactions you had in the year it can be pretty burdensome,” Erik Weinapple, tax director at Moss Adams, says. “Also, it may not be 100% accurate. There might be some missing info such as a historical purchase price of a cryptocurrency originally purchased on another exchange.”

Those who use wallets to own digital assets better roll up their sleeves, Weinapple says. Wallets generally don’t compile records for users. The only way to gather the cost basis of every asset traded is to dig into your transaction history –a tedious task for anyone who actively traded.

Software designed for crypto traders, such as Cointracker and TokenTax can help ease some pain, but beware their shortcomings, says Jon Feldhammer, a tax attorney at Baker Botts.

“I just had a client who used one of the apps and it considered some transfers to his own wallet from another wallet to be taxable–but they are not,” he says. “You have to screen information carefully.”

Zac McClure, founder of TokenTax, says software companies face a big problem with imperfect data that’s either improperly gathered by individuals or reported to individuals by exchanges. It’s common for reports issued by big exchanges to improperly note transfers of digital assets as taxable, he says. “I’ve seen hundreds of people who overpaid taxes for this reason.” The gray areas in the tax law also pose a challenge, he says

What Is Taxable, What Is Not

The IRS views digital assets as property, and as with stocks and real estate, realized gains are subject to short-term capital-gains tax rates of up to 37% if the asset was held less than a year, and long-term rates of up to 20% if held for more than a year. Losses can be used to offset gains. Excess losses of up to $3,000 per year can offset income, or be carried forward to future years.

There is some good news for investors. If you held a digital asset last year, and received no interest on your cryptocurrency through staking–when you lock up your cryptocurrency on your digital platform to earn interest–there is no need to report your crypto activity on your tax return.

Other non-taxable and non-reportable transactions: receiving crypto currency as a gift and transferring cryptocurrency between wallets.

But if your crypto assets were sold for dollars, traded for other crypto assets or used for a purchase in the virtual or real world, the resulting gains and losses must be reported.

Cryptocurrency earned through mining or compensation is considered income, and is taxed at income tax rates.

Where the Law Is Murky

It’s still not clear how long-term capital gains on non-fungible tokens (NFTs) should be taxed, Weinapple says. NFTs are digital certificates of authenticity—essentially a bit of code stored on a blockchain—that usually represent art, music or videos.

While NFTs auctioned through Sotheby’s may classify as art, and others like digital trading cards may classify as collectibles–NFTs are tokens that could be viewed on par with cryptocurrencies from a tax perspective, Weinapple says. The top long-term tax rate is 28% for art and collectibles and 20% for cryptocurrencies

Another gray area is how to treat the interest earned through staking. The issue is central to a current case in district tax court in Tennessee, in which a taxpayer argues that $3,800 earned in staking interest shouldn’t be taxable because it was not sold or traded.

Also murky is whether the wash-sale rule—which prevents investors from repurchasing the same stock within 30 days of selling it and claiming a loss—applies to crypto.

“These are 100% gray areas, and there is a conservative and aggressive position taxpayers can take,” says Matt Metras, an enrolled agent at MDM Financial Services in Rochester, NY, who is seeing more NFT transactions within video games. “I’m in the middle of dissecting a clients’ activity in DeFi Kingdoms, in which you can work to create NFTs that you can buy and sell outside the game– it’s easy to engage in these transactions and not think about the tax impacts. ”

Metras and Weinapple recommend leaning conservative: Use your best judgment when classifying NFTs, and pay taxes on interest from staking. For those who don’t, keep careful records in case of an IRS audit.

McClure advises that when it comes to the wash-sale rule, intent will matter if you are audited by the IRS. “If a trade looks like it was only for tax purposes, the IRS may disallow it.”

How the IRS Is Cracking Down

To improve taxpayer awareness and compliance, the IRS moved a check-box question about digital asset activity to the top of Form 1040 starting in 2020.

The agency issued summonses to exchanges Coinbase and, more recently to Kraken and Circle for taxpayer records.

“It can feed that information into an application it has created,” Feldhammer says. “That way it can start tracking trades back to the names of individuals.”

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