Opinion: How is crypto taxed? It’s not clear, and that’s a problem

One of the many questions raised by cryptocurrency is how to tax this new world of digital assets. It creates real concerns about tax evasion.

Crypto was explicitly developed to allow people to transfer currency to each other directly, bypassing the supervision of financial institutions. The Internal Revenue Service relies on information shared by these financial institutions to ensure tax compliance — a system that cryptocurrency defies. The crypto space has well-documented anarchist roots, and it has largely been averse to government regulation. Cryptocurrency and blockchain – complex and emerging technologies – were not designed with tax returns in mind.

The IRS has made some things clear about crypto taxes. As of now, individual taxpayers must answer questions about whether they have participated in digital asset transactions. If I buy a token it doubles in value and then I sell it, I have to pay capital gains tax. Last month, the tax authorities issued a reminder that income from transactions with digital assets must be reported. And it recently issued much-needed guidance on when NFTs, or non-fungible tokens, should be taxed as collectibles. Congress enacted new reporting requirements for crypto broker-dealers in 2021, and the Treasury Department is expected to issue regulations on these requirements soon.

But the federal government has yet to answer very real questions from crypto investors and participants about how to report their earnings. When is crypto mining a hobby and when is it a business? Does a taxpayer realize a gain or loss when they lend cryptocurrency? If a US resident stakes cryptocurrency (meaning it is pooled with other crypto in a system to validate the blockchain, from which rewards are collected) via an offshore server, which country gets taxed on the resulting income? Your tax bills will look very different depending on the answers to these questions.

If crypto income is not fully and appropriately taxed, the consequences can extend far beyond the blockchain. Effective crypto taxation promises significant revenue: The new broker-dealer reporting requirements alone could raise an estimated $28 billion over the next decade.

Also, the IRS relies on high levels of voluntary compliance from Americans. Given the extremely low risk of audit (IRS data from the 2019 tax year indicates that only 0.25% of taxpayers are audited) and low penalties for underpayers, tax evasion should be widespread. Why isn’t it? One explanation is tax morale: the non-rational reasons why people choose to file and pay, including social norms and the belief that others in their community will also pay.

Unfortunately, tax morality is an unreliable enforcer of tax law. When people begin to see that others do not pay taxes, or they begin to see the tax system as illegitimate, they are less likely to comply themselves. This could set off a nasty feedback cycle, wreaking havoc on the already overstretched tax authorities and draining vital government revenue.

This is why the stakes are so high for crypto taxation. Getting it right is about the legitimacy and effectiveness of our entire tax system.

In a vacuum of government guidance, two specific tax morality issues emerge for crypto. First, the lack of clarity gives crypto interest groups opportunities for legal arbitrage. They can take advantage of the uncertainty surrounding this new technology, and the complexity of our tax system, to seek tax outcomes through the courts that override the intent of existing law or policy. This in turn can damage tax morale.

Second, the confusion may deter crypto investors and participants who genuinely want to pay taxes from doing so. Reading through conversations on the r/CryptoTax subreddit reveals that many people trying to comply with tax laws can’t figure out how to do it. If this confusion ultimately discourages taxpayers from paying on their crypto earnings, it will create more examples of people successfully avoiding taxes, and tax morale could suffer.

Treasury and the IRS should provide timely guidance on the open questions for crypto taxation, based on the recent guidance for NFTs. Congress should consider whether new or updated laws are also needed to ensure a comprehensive and coherent system for digital assets.

By April 18, most Americans will have voluntarily filed and paid their taxes (although Californians affected by winter’s storms have until October). Voluntary tax compliance is important – and fragile. We shouldn’t let crypto raise the belief that (most) others are paying their fair share as well.

Amanda Parsons is an associate professor at the University of Colorado Law School. She writes about the intersection between tax law and new technologies.