IRS Increases Scrutiny of Cryptocurrency Activity, Provides Loss Deductions and Guidance for NFT Tax Treatment

The IRS has significantly increased its scrutiny of cryptocurrency and other digital currency transactions in recent years, and this trend will accelerate this year and beyond. The agency is closely monitoring the tax implications of trading in digital currencies, including non-fungible tokens (NFTs).

Among the ways the IRS tracks individuals who engage in these transactions is by asking the question on Form 1040. For the 2020 tax year, Form 1040 asked whether at any time during 2020 the taxpayer received, sold, sent, exchanged, or otherwise acquired financial interests in a virtual currency. 164,358,792,1040 returns were submitted in 2020, and the responses were distributed as follows:

• Yes: 2,226,516
• no.: 147.171.652

For the 2022 tax year, the IRS expanded the question, and many more taxpayers are expected to answer yes, as I discussed earlier this year: The IRS requires all taxpayers to answer questions about digital assets on their 2022 FY Form 1040s.

How cryptocurrency is treated for federal tax purposes

Cryptocurrency is treated as property for tax purposes, meaning that gains or losses from sales or exchanges are subject to capital gains tax. This means that individuals who sell their cryptocurrency or NFT at a profit must report the transaction on their tax return and pay tax.

Our AnswerConnect team recently published a deep dive into virtual currencies, cryptocurrencies and state taxes, including which states tax digital assets and/or virtual currencies.

Tax enforcement of cryptocurrency

As one tool to enforce compliance with these rules, the IRS uses Form 1040 to track individuals who trade cryptocurrencies and NFTs. The current version of the form includes a virtual currency question, specifically asking if the taxpayer received, sold, sent, exchanged, or otherwise acquired any economic interest in virtual currency during the 2022 tax year.

In addition, the IRS is working with blockchain analytics firms to identify individuals who may be evading taxes by using cryptocurrency to hide their income.

Advisory Memorandum on Deduction of Cryptocurrency Losses

Recently, the IRS issued a Chief Counsel Advice Memorandum (CCA 202302011). The note states that taxpayers cannot claim a deduction for cryptocurrency losses that – without a sale or other taxable disposition – have significantly decreased in value if the cryptocurrency continues to trade on at least one cryptocurrency exchange and has a value greater than zero.

In addition, the guidance states that taxpayers who purchased cryptocurrency for personal investment and had cryptocurrency losses due to worthlessness or abandonment could not deduct the losses. This affects taxpayers for tax years 2018-2025 due to the limitations on various itemized deductions.

The guidance also clarifies several key issues related to the taxation of digital currency assets, including the definition of “virtual currency”, the tax treatment of hard forks and airdrops, and the tax implications of holding digital currency in a foreign account.

It defines virtual currency as “a digital representation of value that serves as a medium of exchange, a unit of account, and/or a store of value.” This definition is similar to that used by the Financial Crimes Enforcement Network (FinCEN), an agency of the US Treasury Department.

The guidance also clarifies the tax treatment of hard forks and airdrops. A hard fork occurs when a blockchain splits into two separate chains, while an airdrop occurs when a person receives cryptocurrency for free, typically as a result of holding another cryptocurrency. It states that the tax treatment of these events depends on the specific facts and circumstances of each case.

Finally, the note provides information on the tax consequences of holding digital currency in a foreign account. In particular, it indicates that US taxpayers who hold digital currency in a foreign account must report the account on their tax return and may be penalized for not doing so.

Provisional guidance provided on tax treatment of NFTs

On March 21, 2023, the Internal Revenue Service issued Interim Guidance 2023-27 on the tax treatment of non-fungible tokens (NFTs), digital collectibles. The agency also requested feedback for upcoming guidance on these digital assets.

Until further guidance is issued, the IRS stated that it intends to determine when an NFT is treated as a collectible using a “look-through analysis.” During the look-through analysis, an NFT is treated as a collectible if the NFT’s associated right or asset falls under the definition of collectible in the Tax Act. For example, a gemstone is a collectible under section 408(m); therefore, an NFT that certifies ownership of a pearl is a collector’s item.

An NFT is a unique digital identifier registered using distributed ledger technology and can be used to certify the authenticity and ownership of an associated right or asset.

Distributed ledger technology, such as blockchain technology, uses independent digital systems to record, share and synchronize transactions, the details of which are recorded simultaneously across multiple nodes in a network.

A token is a record of data encoded on a distributed ledger. A distributed ledger can be used to identify ownership of both NFTs and fungible tokens, such as cryptocurrency, as described in Rev. Roll. 2019-24.

Final thoughts

Clearly, individuals who engage in cryptocurrency transactions, including NFTs, should be aware of the tax implications of their activities. The IRS closely monitors these transactions and uses Form 1040 and other methods to track individuals who participate in them.

The IRS Chief Counsel’s office’s recent memo clarifies several key issues related to the taxation of digital currency assets.

The preliminary guidance issued by the agency on March 21 treats NFTs as collectibles based on Internal Revenue Code section 408(m), which defines a collectible as “any tangible personal property that is capital gain property and that is owned by the taxpayer for more than 12 months primarily to appreciate its value.”

The IRS guidance means that NFTs will be subject to a 28% capital gains tax rate when sold. This is higher than the 15% capital gains tax rate that applies to most other types of assets.

Some believe that NFTs should not be treated as collectibles because they are not tangible personal property, and many expect this treatment to face a legal challenge. However, this guidance is preliminary and we can expect further notice from the IRS in the coming months.