Add to a tough year for Bitcoin and other cryptocurrencies: The IRS proposes a new question about your digital assets

For two years, the IRS has been asking whether taxpayers have bought or sold cryptocurrency in the main “Form 1040” document that taxpayers file for their federal income taxes. It’s a “yes” or “no” question that taxpayers can’t leave blank.

Last year, Form 1040’s asked, “Did you receive, sell, exchange or otherwise dispose of economic interests in a virtual currency?” (The wording differed slightly from the language that appeared on the previous year’s Form 1040.)

The prominent placement is a nod to the tax authorities’ increasingly sharper focus on ensuring that cryptocurrency investors fully meet their tax obligations.

Fast forward to next year’s tax returns: The IRS has proposed a draft question asking for next year’s Form 1040: “At any time during 2022, did you: (a) receive (as a reward, reward or compensation); or (b) sell, exchange, gift or otherwise dispose of a digital asset (or an economic interest in a digital asset)?”

However, after the IRS unveiled the question’s proposed wording ahead of the 2023 tax season, the American Institute of CPAs recommended the IRS get out the pencils and erasers. The tax authority needs to clarify the issue to avoid confusion on the part of taxpayers, the organization said in its comment letter.

Generally speaking, capital gains taxes will hit sales, exchanged coins, obtaining cryptocurrency through mining, and other scenarios. But buying cryptocurrency and then just holding it has not is considered a taxable event. When jobs pay with cryptocurrency, for example, they are generally treated as wages subject to employment taxes, the IRS says.

In some ways, the latest version of the question is an improvement, said Annette Nellen, a tax professor at San Jose State University who chairs the AICPA’s virtual currency task force. But including the phrase “‘digital asset’ is going to create new problems and new confusion,” she said.

Apart from cryptocurrency like Bitcoin BTCUSD,
-1.09%
or Ethereum ETHE,
+0.60%
ETH USD,
-0.76%,
use of a phrase such as “digital asset” raised questions about whether the tax authorities were also asking about non-fungible tokens (NFTs) and in-game currency such as Fortnite’s V-Bucks or Robux offered on Roblox RBLX,
+0.20%,
The AICPA noted.

The IRS has previously removed V-Bucks and Robux from examples of virtual currency that can be converted to real money. However, creating, buying and selling NFTs can have tax implications.

So what is the solution? The best approach would be a matter of asking whether during the year taxpayers had “a taxable event involving virtual currency” and then pointing to instructions about what that means, the AICPA said in its comment letter.

These instructions, it added, should specify that an individual filer does not need to check “yes” if their child or dependent had their own cryptocurrency-related tax events that generated income below the filing thresholds.

The back-and-forth on the wording of tax documents may sound like dry semantics, but it underscores how much is still being discovered about cryptocurrency, taxes — and the public’s continued need to understand the ways the two interact.

The AICPA’s comment letter wants the IRS to stick with the term “virtual currency” instead of “digital asset” for the time being. But even so, it notes, there are variations in how tax authorities formally and informally define “virtual currency” in their guidance and instructions.

One reason investors need to understand the tax rules now is because it can help offset some of their losses in 2022. Investors can use capital losses to offset their gains. If the losses exceed the gains — and that may be the unfortunate case for some hard-hit cryptocurrency investors — a taxpayer can claim up to $3,000 in capital losses. Any remaining deficit can be carried forward to future tax years.

Bitcoin BTCUSD,
-1.09%
traded above $20,000 on Thursday, down nearly 57% year-to-date. Ethereum ETHUSD,
-0.76%
is down more than 57% year to date.

Nearly two in 10 American adults said they owned cryptocurrency in August, according to an ongoing Morning Consult survey. The 18% in August is about the same as the start of the year.

Matt Metras of MDM Financial Services in Rochester, NY, has a glowing view of the question the IRS is trying to ask. “It’s not perfect, but it’s better than it was last year,” said Metras, who specializes in tax preparation for cryptocurrency owners. “The use of digital assets is more inclusive,” he said.

Still, Metras doesn’t know if there will ever be a crystal-clear, concise, and perfectly worded way for the IRS to ask about cryptocurrency holdings. The landscape continues to change so quickly, he noted.

The agency thinks about “readability and the information to be collected,” when it puts new language on a tax form, said Michael Kramarz, director of Kaufman Rossin’s tax services advisory group.

“A taxpayer’s response to an information request on a tax form is only as good as the question asked. If a taxpayer can’t understand the language on a tax form, the IRS won’t be able to gather the type and breadth of information it seeks, says Kramarz, a former IRS attorney.

The tax authorities will consider comments from tax experts and the general public when coming up with the wording of the tax document, Kramarz noted. They can submit comments here.

Typically, completed tax forms start rolling out around November and December, Nellen said. The tax authorities refused to comment.

In Metra’s view, “There’s a lot of confusion out there in the general public about what’s reportable and what’s not,” with cryptocurrency. As a result, “there are people out there doing it who are unsure about the question.”

Now cryptocurrency owners and tax experts will have to wait for the tax authorities’ final wording. “How it ends up is always a fun surprise,” Metras said.