Compounding a disastrous year for Bitcoin and other cryptocurrencies: IRS proposes controversial new question on digital assets

By Andrew Cashner

Investors may need all the help they can get from the tax code’s capital loss rules

Cryptocurrency investors have endured a year in which their holdings have fallen in value as some hoped the asset could be a hedge against red-hot inflation

The Internal Revenue Service could have a potential head-scratcher of a question about your crypto investments and what is taxable, according to a major accounting association.

For two years, the IRS has asked whether taxpayers have bought or sold cryptocurrency in the main “Form 1040” document that taxpayers file for their federal income taxes. The inquiry also asks about other potential crypto-related tax events. It is a “yes” or “no” question that taxpayers cannot leave blank

Last year, Form 1040s 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 Form 1040 the previous year. The question first appeared in tax year 2019, on Form 1.)

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 return: The IRS has proposed a draft question asking on next year’s Form 1040: “At any time during 2022, did you: (a) receive (as a reward, prize, 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 counted as 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.

Aside from cryptocurrency like Bitcoin or Ethereum, using a phrase like “digital asset” raised questions about whether the tax authorities were also asking about non-fungible tokens (NFTs) and gaming currency like Fortnite’s V-Bucks or Robux offered on Roblox (RBLX), 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 branch does not need to check “yes” if the 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 losses exceed 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 traded above $20,000 on Thursday, down nearly 57% from the start of the year. Ethereum is down more than 57% so far this year.

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 adding new language to 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 cannot understand the language on a tax form, the IRS will not be able to gather the type and breadth of information it seeks,” said 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 uncertain 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.

-Andrew Cashner

(END) Dow Jones Newswires

09-03-22 1104ET

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