The landscape of digital assets is rapidly evolving, and with the IRS stepping up its enforcement efforts, tax professionals are likely to encounter an uptick in tax notices related to cryptocurrency underreporting. While cryptocurrencies and digital assets are not new concepts, the complexities surrounding taxable events and accurate income reporting continue to cause confusion. This article aims to explain the nuances of digital asset taxation and offer practical advice to ease the tax season's challenges for tax professionals and their clients.

Understanding Digital Assets

To understand digital assets, it's important to know that most countries, including the United States, do not recognize digital assets as actual currency. They differ from physical coins and paper money distributed by governments, as well as digital currency issued by banks. Digital assets are a substitute for real currency and are assigned a value equivalent to that of real currency. For example, at the time of writing this article, one Bitcoin is worth USD 51,346.40. Individuals can use Bitcoin to pay for goods and services, trade it with other users, or exchange it for other digital assets or real currency.

Types of Digital Assets Include:

• Convertible virtual currency and cryptocurrency (ex. Bitcoin)

• Stablecoins

• Non-fungible tokens (NFTs)

• And, more.

Cryptocurrency's Evolution

Introduced in 2009 with Bitcoin, the cryptocurrency market has since expanded to over 23,000 varieties, with Bitcoin remaining the most prevalent. Despite its growing popularity, the technological foundations (e.g., blockchain) and tax implications of cryptocurrency use continue to puzzle both taxpayers and tax professionals. The IRS's focused attention on cryptocurrency underscores the importance of compliance and accurate reporting.

Taxable Events

Although cryptocurrency is often referred to as a virtual currency, it is not yet recognized by the IRS as such. Instead, it is classified as property and taxed accordingly. This means that any income generated from buying and selling cryptocurrencies is considered taxable income.

Key taxable events include:

• Sale of Digital Assets for Fiat Currency: Conversion of digital assets to traditional currency is taxable, with the holding period influencing capital gains or losses.

• Exchange of Digital Assets for Goods or Services: Transactions involving cryptocurrencies as payment for goods or services require the tracking of capital gains or losses, with detailed documentation of each transaction's date, value, and market price.

• Receipt of Digital Assets as Payment: Similar to the seller, the recipient must also track and report capital gains or losses when receiving digital assets in exchange for goods or services.

• Exchange or Trade of Digital Assets: Direct exchanges of one type of cryptocurrency for another are taxable, necessitating accurate tracking of the cost basis for each transaction.

• Receipt of New Digital Assets from Hard Forks: The receipt of new cryptocurrencies resulting from hard forks is taxable, with obligations arising even if there were administrative issues during distribution.

• Mining or Staking Activities: Earnings from mining or staking, where cryptocurrencies are received in exchange for validating transactions or supporting the network, are considered taxable income.

• Receipt of Digital Assets through Airdrops: Airdrops, used by startups to distribute new cryptocurrencies, trigger tax liabilities for recipients.

Non-Taxable Events

Certain activities, such as purchasing cryptocurrencies with fiat money, donating to charities, gifting, and transferring assets between one's wallets, do not trigger tax liabilities, offering some relief amidst the complexity.

Tax Reporting Best Practices

Accurate record-keeping is critical for cryptocurrency transactions due to their decentralized and pseudonymous nature. Taxpayers are encouraged to maintain detailed records of all transactions, including dates, amounts, and market values at the time of each and every transaction. Whether managed manually through detailed spreadsheets or specialized software, such records are crucial for tracking the cost basis of transactions, a frequently overlooked yet essential piece of information for tax reporting.

Additionally, understanding and correctly answering the cryptocurrency question on tax forms like Form 1040 is important. Taxpayers must accurately report all transactions involving digital assets, encompassing receipt, disposal, or exchange, among other activities, to remain compliant with IRS regulations.

IRS Questions and New Regulations

The Infrastructure Investment and Jobs Act and subsequent proposals to broaden the definition of brokers underline the shifting regulatory environment surrounding digital assets. These changes, aiming to bridge the tax gap attributed to underreported cryptocurrency transactions, require tax professionals to stay informed about reporting obligations, including the issuance of 1099-DA forms by cryptocurrency exchanges.

Future Outlook and Resources

As innovations like spot ETFs tracking Bitcoin's market value emerge, the digital asset sector's complexity continues to grow. For tax professionals, staying updated through the IRS website and using resources like Protection Plus becomes crucial. These practices ensure that professionals can navigate digital asset taxation confidently, offering informed guidance and compliance strategies in this rapidly evolving field.

By: Diane Mahoney, Enrolled Agent – [Protection Plus] Case Management Team Lead 
       Maria Murphy, [Protection Plus] Marketing Content & Design Manager

Featured in the May 2024 issue of NATP TAXPRO Magazine