By Anthony Diosdi
Cryptocurrency has grown in popularity and ubiquity in the past few years. Cryptocurrency is a type of digital or virtual currency that uses cryptography for security. Virtual currency is a digital representation of value that functions as:
1) A medium of exchange;
2) A unit of account; and
3) A store of value other than a representation of the United States dollar or a foreign currency.
Cryptocurrency allows parties to transact directly without an intermediary using blockchain technology, a shared distributed ledger that verifies, records, and settles transactions on a secure, encrypted network. Although some major retainers accept cryptocurrencies like Bitcoin, cryptocurrency is not money. Money means coin and paper money that Congress declares is legal tender. Cryptocurrency is also unlikely to be a “security,” with the possible exception of security tokens and stablecoin (discussed below). However, cryptocurrency may be classified as a “commodity.” The Commodity Futures Trading Commission (“CFTC”) has declared certain cryptocurrencies, including Bitcoin and Ethereum, as commodities, and Bitcoin futures are traded on the Chicago Mercantile Exchange (“CME”).
Cryptocurrencies are extremely volatile, especially compared with conventional financial instruments like stocks and bonds. That volatility plays a central role in the appeal of virtual currency. However, there is now a subset of cryptocurrencies known as stablecoins that are intended to be “stable” versus a fiat currency (Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it). Stablecoins are a type of cryptocurrency in which the issuer will often put high-quality liquid assets in reserve to ensure repayment of the virtual currency. The holder is typically entitled to redeem stablecoin on demand in exchange for a referenced asset. Common examples of stablecoin include USDC (Circle), USDT (Tether). This article focuses on how virtual currency and NFS are taxed and the wider implications of virtual currency reporting requirements.
The Taxation of Cryptocurrency
Virtual currencies are treated as property and not currency for federal tax purposes in the United States. This is a departure from the rest of the world which treats virtual currency the same as standard fiat currency. Internal Revenue Service (“IRS”) Notice 2014-21, provides that taxpayers must recognize gain or loss on the exchange of virtual currency for cash or for other property. Notice 2014-21 concluded that “convertible virtual currency,” i.e., virtual currency that has an equivalent value in fiat currency or is used as a substitute for fiat currency, is property that is not currency under Internal Revenue Code Section 988. As a result, “[g]eneral tax principles applicable to property transactions apply to transactions using virtual currency.”
Gain or loss is, thus, recognized and taxable, every time that virtual currency is sold or used to purchase goods or services, including other types of virtual currency. To determine the amount of capital gain or loss, an individual using cryptocurrency must know the basis of the virtual currency and the fair market value of the cryptocurrency when sold or otherwise transferred. In order to determine the proper capital gains rate, a determination must be made how long the cryptocurrency was held before its liquidation. Short-term capital gain is the gain occurring from the sale or exchange of virtual currency when it is held less than one year. Long term capital gain is the gain that occurs from the sale or exchange of virtual currency when it is held for more than one year. Under the current tax rate, the federal rates on long-term capital gains are taxed at rates up to 20 percent, plus 3.8 percent Medicare Tax (in certain cases), plus applicable state and local tax.
Basis of Cryptocurrencies For Tax Purposes
As discussed above, cryptocurrency is a capital asset for income tax purposes. This means that a trader in cryptocurrency must determine his or her cost basis in the virtual currency when it is sold. The cost basis is the amount an investor spent to acquire an asset. This includes the purchase price, transaction fees, commissions paid, and any other relevant costs. At first glance, calculating the cost or initial basis in virtual currency seems simple. When U.S. dollars are used to acquire cryptocurrency, the basis in the cryptocurrency is the amount of fiat currency used to purchase the virtual currency. This is no different than the rules for determining the basis in any other capital asset. However, determining the basis in cryptocurrency quickly becomes more difficult after this initial stage in basis calculation.
The main reason it can be difficult to determine the basis of cryptocurrency is the method used to acquire the virtual currency. Cryptocurrencies are often acquired through a cryptocurrency trading platform or exchange. In these cases, the cost basis of the cryptocurrency is the amount that is recorded by the cryptocurrency exchange for that transaction. However, if the acquisition of the cryptocurrency happens “off-chain,” which means the transaction is not recorded on the distribution ledger, then the basis is the amount the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it were on “on-chain” transaction. If cryptocurrency is acquired in a peer-to-peer transaction or some other transaction that does not involve a platform or exchange, the basis of the cryptocurrency is determined as of the date and time the transaction is recorded on the distribution ledger or would have been recorded on the ledger if it is an “off-chain” translation.
The method of acquiring cryptocurrency is not the only factor that determines the cost basis of cryptocurrency. The cost basis of an investor’s cryptocurrency depends on his or her method of tax accounting. There are three methods of tax accounting for purposes of cost basis calculation:
1) Determine cryptocurrency taxation under first-in, first-out (“FIFO”). FIFO is an assumption that the first goods acquired or produced should be assigned to the first goods sold.
2) Determine cryptocurrency taxation under last in, first-out (“LIFO”). LIFO is an assumption that the cost of the goods most recently acquired or produced should be assigned to the first goods sold.
3) Determine cryptocurrency taxation under the highest-in, first-out (“HIFO”) method. HIFO is used when inventory with the highest cost of purchase is the first to be used or taken out of stock.
A simple example how a cryptocurrency trader would calculate his or her basis would be as follows; suppose an investor uses FIFO to determine his or her tax basis and the investor acquired one Dogecoin in 2018 and two Dogecoin coins in 2019. If the investor sells two Dogecoins in 2021, the trader would use the cost basis for the one Dogecoin purposed 2018 and the cost basis for the Dogecoin purposed in 2019 to his or her tax basis.
Determining cost basis becomes more complicated if there are multiple coin transactions. For example, assume that a cryptocurrency investor has 10 coins of virtual currency at a cost of $1 per coin acquires additional virtual coins at the following times and costs:
Assuming that 12 coins remain on hand at the end of the year, it is necessary to determine what portion of the $51.50 aggregate cost should be allocated to these 12 virtual coins. Under LIFO, the ending inventory of virtual coins would be deemed to cost $12.04 (consisting of a layer of 10 virtual coins at $1.00 per coin and a layer of 2 coins at $1.02 per coin). The balance of $39.46 would be allocated to the cost basis. Under FIFO, the ending virtual coin inventory would be deemed to cost $12.68 ((10 x $1.06) + (2 x $1.04)), and the balance of $38.82 would be allocated to the cost basis.
Another challenge in basis calculation is when an investor exchanges one cryptocurrency for another cryptocurrency. In these cases, investors often cannot directly purchase new virtual currency using fiat currency. Instead, the cryptocurrency can only be acquired through major cryptocurrencies such as bitcoin or ethereum. only by exchanging major cryptocurrencies. From a cost basis calculation point of view, the exchange of cryptocurrency is crucial because one capital asset is being liquidated to purchase another capital asset. This type of transaction not only triggers a taxable event from the disposition, but it also requires the basis to be calculated on the newly acquired cryptocurrency.
Prior to the IRS releasing its FAQs on virtual currency, it was thought that since virtual currency is usually held for investment purposes, like stock, it should be subject to the same basis and accounting rules as stock and as such, unless other specific exceptions are made. The “FIFO method should be used in identifying which ‘coin’ is sold or transferred, which determines the gain or loss of the transaction. One of the exceptions to FIFO as it relates to stock as if there can be “adequate identification.” The obvious issue with adequate identification is whether that could ever be applied to virtual currency. With bitcoin, for example, there is no actual “coin;” it is just an entry on a distributed ledger. Fortunately, the IRS did provide guidance in its FAQs that permit investors to choose which units of virtual currency are sold if those units can be “specifically identified.” If the units of virtual currency are not specifically identified then the first in, first out method is to be used. An investor can use specific identification by documenting the specific unit’s unique digital identifier, such as a private key, and address, or by records showing the transaction information for all units of a specific virtual currency held in a single account, wallet, or address.
The ability to use specific identification allows an investor to pick the most advantageous tax treatment and it is further applicable universally across all wallets or virtual currency holdings and not limited to per-wallet application.
The Taxation of Mining Cryptocurrency
We often hear of mining cryptocurrency. Cryptocurrency mining is the process in which transactions between users are verified and added to the blockchain public ledger. The process of mining is also responsible for introducing new coins into the existing circulating supply. The IRS has not provided a large amount of guidance regarding the taxation of mining virtual currency. The primary source of discussion is found in Notice 2014-21, which states the following:
Q-8: Does a taxpayer who “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realize gross income upon receipt of the virtual currency resulting from those activities?
A-8: Yes, when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. See Publication 525, Taxable and Nontaxable Income.
Pursuant to IRS Notice 2014-21, the mined virtual currency has a fair market value, and is included as gross income, as of the date of receipt. The fair market value of the cryptocurrency is determined as of the date and time the transaction is recorded on the distributed ledger. The income from mined virtual currency may also be subject to self-employment tax. See IRS Notice 2014-21, Q-9.
The Tax Controversy of Hard Forks
In 2018, the IRS launched a virtual currency taxation awareness campaign that evolved into a targeted compliance effort in 2019 aimed at taxpayers with virtual currency transactions who failed to report the resulting income and pay the associated taxes. In 2019, the IRS also issued Revenue Ruling 2019-24 which provides guidance regarding the taxation of “hard forks” and “air drops.” For the most part, a hard fork is a blockchain software update used to correct security flaws that adds new functions or reverses transactions. Hard forks do not undo a network’s transaction history, hard forks do create a permanent divergence from the previous blockchain that may require the forced exchange of the old network’s virtual currency for the virtual currency of a new network. A hard fork also results when there is a split in a cryptocurrency’s blockchain.
In brief, a hard fork represents a permanent change to the coding of a virtual currency’s underlying blockchain that necessitates the creation of a separate and distinct cryptocurrency. A hard fork will impact the basis and taxation of cryptocurrency. However, the IRS and the Department of Treasury have yet to issue comprehensive guidance in this area.
There are currently three theories as to how a hard fork will impact the basis and taxation of cryptocurrency. Some view a hard fork as the receipt of a new asset. Under this view, the investor would recognize ordinary income on the opening market value of the new cryptocurrency against the cost basis of the ordinary acquired cryptocurrency. A second view is to treat a hard fork as a spinoff or stock split in which the existing cryptocurrency splits into two. Under this theory, the virtual currency trader would immediately recognize income on the new cryptocurrency received and would split with the cost basis tacked on the original cryptocurrency between the two using the respective market values following the split using the best available data. Anyone considering taking this position should understand that the IRS would likely challenge it. This is because this theory does not fit well into the existing provisions allowing for nonrecognition treatment. A third approach and final approach is to apply a zero basis to the new cryptocurrency. The rationale behind this approach is that although the new cryptocurrency may be a new asset, the validity of the cryptocurrency market makes assigning a market value immediate to it difficult. Anyone virtual currency transfer involved in a “hard fork” transaction, should seek professional advice as to how to report the transaction.
Finally, another transaction unique to cryptocurrency is the airdrop. IRS Rev. Rul. 2019-24 explains that investors who receive an “airdrop” of units of new virtual currency to their digital wallet after a hard fork realize ordinary gross income on the date the new currency is received regardless of whether that currency is converted into U.S. dollars.
The challenge with this treatment is taxpayers may not be aware that an airdrop has occurred.
Virtual Currency Received for Services
If an investor receives virtual currency in exchange for services, the income is the fair market value of the virtual currency on the date acquired and is possibly subject to self-employment tax. The foundation for this can be found in Internal Revenue Code Section 83. Under Section 83, which deals with property transferred in connection with performance of services, property transferred in exchange for services is immediately taxable at the time the property is transferable or there is not a substantial risk of forfeiture. In the virtual currency context, this would occur when the cryptocurrency is credited and available for transfer in exchange for the service.
Revenue Rule 80-52 provides additional guidance for virtual currency exchanged for services. Revenue Rule 80-52 discusses a barter club that uses “credit units” as a medium of exchange. The club debited or credited members’ accounts for goods or services received or rendered to other members. The ruling stated as follows:
In this case, A, B, and C received income in the form of a valuable right represented by credit units that can be used immediately to purchase goods or services offered by other members of the barter club. There are no restrictions on their use of the credit units because A, B, and C are free to use the credit units to produce goods or services when the credit units are credited to their accounts.
Consequently, according to Revenue Ruling 80-52, members receiving credit to their barter club were required to recognize income pursuant to Section 83 of the Internal Revenue Code.
Losses of Individuals Trading in Cryptocurrencies
Sometimes Individuals trading in cryptocurrencies suffer losses. Internal Revenue Code Section 165(a) allows a deduction for losses sustained during the tax year not compensated by insurance or otherwise. However, Section 165(c) of the Internal Revenue Code limits deductions by individuals to those losses incurred in a trade or business or losses incurred in any transaction entered into for profit. Thus, a trader may only use losses from digital currency trades against similar gains. This is the case even if a gain on the same transaction would be taxable. In addition, the deduction for capital losses is limited to the extent allowed under Internal Revenue Code Sections 1211 and 1212. Under these rules, an individual investor is allowed to utilize losses to the extent of the gains from sales, plus $3,000 ($1,500 in the case of a married individual filing a separate return). Since cryptocurrencies are not securities, an investor cannot utilize the Section 165(g) worthless security loss rules. (Under Section 165(g)(1) of the Internal Revenue Code, if a security that is a capital asset becomes worthless during the tax year, the resulting loss that is treated as a loss from the sale or exchange of a capital asset on the last day of that tax year).
Theft of cryptocurrencies have been increasing. Internal Revenue Code Section 165(c)(3) allows a deduction for certain casualty or theft losses not connected to a transaction entered into for profit (or incurred in a trade or business). Because many cryptocurrency are “transactions engaged into for profit, while not associated with a trade or business,” they can be classified as investment losses under Section 165(c). However, under Section 165(h)(5) of the Internal Revenue Code, after 2017, an otherwise deductible personal casualty loss in excess of personal casualty gains generally may be deducted only to the extent attributable to a disaster declared by the President. Section 165(h)(5) of the Internal Revenue Code is set to sunset in 2026. Until Section 165(h)(5) expires in 2026, theft losses are not deductible by individuals outside the context of a federally-declared disaster.
Wash Sales Applied to Cryptocurrencies
A cryptocurrency trader experiences a wash sale when he or she sells or trades virtual currency at a loss and then buys it back again. Cryptocurrency investors may take advantage of the losses and then carry them forward into an unlimited number of tax years. Internal Revenue Code Section 1091 disallows any loss from the sale or disposition of stock or securities where, within 30 days before the date of the sale or within 30 days after such sale, the investor acquired substantially identical stock or securities. Since cryptocurrency is not a stock or security, the Section 1091 “wash sale rules” do not apply to cryptocurrency transactions. These rules may change in the near future however. The House Ways and Means Committee proposes to expand the types of assets subject to the wash sale rules to include, for example, commodities, foreign currencies, and “digital assets,” which would include most if not all virtual currency.
Treatment Tax Treatment of Cryptocurrency Futures
A futures contract is an agreement between two parties to buy or sell an asset on a given future date for a specified price agreed upon. When a cryptocurrency investor buys a futures contract, he or she does not own the underlying asset; the investor owns a legal contract which gives the investor the right to buy or sell the underlying asset at a future date for a set price. In the cryptocurrency ecosystem, a significant number of futures contracts are cash settled. This means that there is no physical exchange of cryptocurrency between the two parties at the contract expiration. Instead, the investor receives the price difference between the position entry and the exit position. The price difference is reflected on a line item labeled as “Pnl” or “Profit/Loss” on most exchange interfaces. We will now discuss the tax consequences of these contracts.
Most cryptocurrency futures contracts currently offered are considered unregulated because they are not governed by the CFTC. Thus, these contracts do not receive any favorable tax treatment. In these cases, if an investor makes a profit by selling unregulated cryptocurrency futures, the gains will be taxed as either long or short term capital gains. Futures contracts that are regulated by the CFTC are taxed under the provisions of Internal Revenue Code Section 1256. As a general rule, investors are not taxed on gains in virtual currency positions until the positions are sold. Under Section 1256, special tax rules can apply to futures contracts involving cryptocurrency. Section 1256 may require cryptocurrency investors to treat their gains on certain virtual currency positions as taxable even though they still hold their positions. This is referred to as marking their positions to market for tax purposes.
The special rules of Section 1256 includes a requirement in which investors mark open positions to market annually. Two of the five types of enumerated Section 1256 contracts are potentially relevant to taxpayers buying, selling, and holding virtual currency futures and options. The mark-to-market rule provides that Section 1256 contracts open on the last day of the taxable year are marked-to-market; that is, treated as if they were sold on that date. All unrecognized gains and losses are taken into account. In other words, open Section 1256 futures and options are treated as if they were sold for their fair market value on the last business day of the taxable year. The fair market value of such futures or options is their settlement prices. For virtual currency futures and options, for example, their settlement prices are determined by the CME on the last business day of the taxable year. All gains and losses are tallied up and used to compute taxable income. When investors terminate a cryptocurrency’s future or options during the year, these contracts are taxed at the sale or close-out price.
Because taxes are paid on recognized and unrecognized gains and losses, investors holding a cryptocurrency future or option can be required to pay tax on gains that, in fact, they never actually realize. If they continue to hold contracts that were marked-to-market at year end, gains and losses realized in a subsequent tax year are adjusted to reflect gains and losses taken into account in the preceding taxable year. The mark-to-market rule can, therefore, distort income and cause economic hardship if gains that were reported in the first year do not materialize in a subsequent tax year. See Special Tax Rules Apply to Bitcoin Futures and Options and Might Apply to Positions in Ether and Other Virtual Currencies in the Future, Andrea Kramer (June 18, 2020).
A Section 1256 contract is not only subject to the mark-to-market rules, they are also subject to the 60/40 rule. Under the 60/40 rule, CME’s cryptocurrency futures and other options are capital assets in investor’s hands that are taxed as 60 percent long-term and 40 percent short-term capital gain or loss. The 60/40 rule applies without regard to the length of time the investor holds such positions, meaning that capital gain holding period requirement is eliminated for Section 1256 contracts. Futures or options that are ordinarily assets in the investor’s hands are not eligible for 60/40 treatment even though they remain subject to mark-to-market. The mark-to-market rule applies to all Section 1256 contracts, without regard to whether they are ordinary or capital, unless the investor is a hedger that made a valid hedge identification.
Investors can elect special loss carryback rules for Section 1256 contract losses that qualify for 60/40 treatment. Eligible investors can use Section 1256 losses incurred in one year to reduce income generated on such contracts in prior tax years. This carryback rule provides a form of income averaging not available to other taxpayers. Taxpayers can carry net Section 1256 contract losses back to each of the three preceding years and apply the losses against Section 1256 contract gains recognized in those prior years. Losses that are carried back are treated as if 60 percent were long-term and 40 percent were short-term. Carryback losses cannot be used to increase or produce a net operating loss for the prior taxable year. Such losses are carried back to the earliest of the three preceding taxable years in which there is a net Section 1256 contract gain. Any portion of the loss not absorbed in the earliest year can then be carried forward to the next taxable year and, if any loss remains, to the next (most recent) taxable year. Any net Section 1256 contract loss carried forward from the first carryback year is again recharacterized as 60 percent long-term and 40 percent short-term capital loss.
Estate and Gift Tax Issues for Nonresident Cryptocurrency Holders
The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $12,060,000.
For nonresident aliens, an estate tax is imposed on any U.S. situs property at the time of death. Situs is determined by the physical location of the nonresident alien decedent’s property. For nonresident aliens a U.S. federal gift applies to transfers of tangible property (real property tangible personal property), including currency) physically located in the United States at the time of the gift.
The question of whether cryptocurrency is tangible or intangible or U.S. situs for gift and estate tax purposes is unsettled. While it would appear obvious that cryptocurrency should be considered intangible, there has been speculation that this may not be the case where a private key associated with the cryptocurrency is stored or located on a hard drive. For these reasons, the IRS may successfully argue that when a private key is stored or located on a hard drive in the United States results in the corresponding cryptocurrency being U.S. situs for gift and estate tax purposes. It should be noted that some U.S.-based cryptocurrency exchanges, such as Coinbase, maintain physical vaults of private keys and, thus, any cryptocurrency held on such an exchange would be at risk of being considered a U.S. situs property.
In determining whether cryptocurrency may be U.S. situs property for purposes of the estate and gift tax, the following factors should be carefully analyzed by an international tax attorney well versed in U.S. wealth transfer tax and cryptocurrency:
1) The location of the owner;
2) Location of the exchange account;
3) Location of the servers;
4) Location of the digital wallet.
Donating appreciated cryptocurrency may be preferable to donating cash from the sales of cryptocurrency. Donations to public charity or certain private foundations may be eligible for full fair market value instead of basis. In other words, if a charity is a recognized organization under the IRS rules, donating cryptocurrency will not result in income, gain or loss. This is consistent with the IRS’s classification of cryptocurrency as an intangible personal property similar to stocks and bonds. Calculating the value of the contributed cryptocurrency depends on the holding period of the donor. If the donor holds the cryptocurrency for one year or longer, then the value of the contribution is equal to the current fair market value of the cryptocurrency. But, if the donor holds the cryptocurrency for less than one year, the value of the contribution for deduction purposes is the lesser of the donor’s adjusted basis or current fair market value of the virtual currency.
The rules for reporting cryptocurrency charitable contributions are essentially the same as those for other contributions to charitable organizations. When accepting cryptocurrency contributions, the charity should provide a contemporaneous written receipt of the contribution. In cases of deductions over $5,000, the charitable organization must sign a Form 8283 and provide the form to the donor.
Cryptocurrency investors are turning to lending primarily for liquidity reasons- by putting up cryptocurrency as collateral, they can continue to invest in the digital currency market while obtaining access to cash. There are two main types of cryptocurrency loans that are discussed below.
The first type of cryptocurrency loan involves one party (the borrower) borrowing virtual currency from another party (the lender) with the borrower posting collateral. The borrower agrees to return to the lender an identical amount of the same virtual currency at the end of the agreement and the lender agrees to return the collateral. These transactions are typically structured to resemble securities lending transactions. The borrower is free to sell or otherwise dispose of the virtual currency subject to the loan, and the lender is often allowed to sell or otherwise dispose of the collateral. If during the term of the agreement there is an airdrop or hard fork with respect to the particular virtual currency that was borrowed, the borrower transfers back to the lender units of virtual currency identical to those that were received in the airdrop or hard fork.
In the second type of transaction, a lender loans the borrower fiat currency and the borrower posts virtual currency with the lender as collateral. A principal objective of these transactions is for the borrower to monetize a virtual currency position without triggering a taxable sale. These transactions are relatively straightforward. When the loan matures, the borrower repays the lender the dollar amount of the loan plus interest, taking back identical virtual currency to that which the borrower had posted as collateral. If during the term of the loan there is an airdrop or hard fork, the lender must transfer to the borrower virtual currency units identical to what is received in the airdrop or hard fork. See Are Crypto Loans Taxed as Loans? Andrea Kramer (July 1, 2020).
What is a Non Fungible Token (“NFT”) and How is a NFT Taxed
The popularity of NFTs has spiked in 2021. (There was $2.5 billion in sales of NFTs during the first and second quarters of 2021). NFTs were just featured on an episode of Saturday Night Live. Recently, the New York Times published an article entitled “Why Did Someone Pay $560,000 for a Picture of My Column?” The article discusses how a reporter wrote a column about NFTs, turned the column itself into a NFT, and put it up for auction. The winning bid for the column was about $560,000.
The concept of an NFT is to marry the world of digital assets with the security of cryptocurrency. An NFT is a digital asset with a certification of authenticity which is protected by copyright law. When one purchases an NFT, that individual is acquiring a hacker-resistant, public proof of ownership of the digital asset. Now since we know a little more about NFTs, it’s time for us to discuss how they are taxed. How an NFT is taxed depends on two factors. First, whether or not an individual created and sold the NFT. Second, whether or not an individual bought and sold the NFT as an investment.
Overview of the Tax Liability for a Creator of an NFT
A creator of an NFT is taxed at the time he or she sells an NFT. For example, let’s assume Bob creates an NFT. Let’s also assume that Bob sold the NFT for one Ether (ETH). Let’s assume that today’s exchange rate for one ETH is $1,976.59. In this case, Bob will report $1,976.59 of ordinary income associated with the sale of the NFT. However, Bob may be able to deduct any business related expenses associated with the creation and sale of the NFT to reduce the tax consequences of the sale.
Overview of the Tax Liability for NFT Investors
Some investors are betting big on the NFT art. Others are acquiring NFTs just for publicity or bragging rights. Whatever the reason for investing in an NFT, the tax consequences associated with buying and selling an NFT is similar to trading digital currencies. Like cryptocurrency, the buying and selling of an NFT creates a taxable profit to the investor. Investors are subject to short or long term capital gains taxes, plus 3.8 percent Medicare Tax, plus applicable state and local taxes.
For example, let’s assume that on April 1, 2021, Linda acquired an NFT worth $3,953.18 (2 ETH). Let’s also assume Linda used 2 ETH to buy the NFT. However, Linda acquired the two ETH used to purchase the NFT a number of years ago. At that time, the 2 ETHs were worth $400. When Linda purchases the NFT, she would incur long-term capital gains on $3,553.18 ($3,953.- $400 = $3,953). Since Linda held the 2 ETH for more than one year, she would be taxed at favorable long-term capital gain rates. Linda’s cost basis in the NFT would be $3,553.18.
If Linda were to sell this NFT in September 2021 for $10,000, she would have a short-term capital gain of $6,446.82 ($10,000 – $3,953.18). The gain is short-term because Linda held the NFT for less than 12 months before she decided to sell it. Short-term gains are subject to favorable rates. This means, Linda will be taxed at ordinary income tax rates on the gain in the NFT. Linda will also be subject to Medicare Tax, and applicable state and local taxes.
It should be noted that an NFT may also be taxed as collectible. Internal Revenue Code Section 408(m)(2) defines a collectible as: 1) any work of art; 2) any rug or antique; 3) any metal or gem; 4) any stamp or coin; 5) any alcoholic beverage; 6) any other tangible personal property specified by the Treasury. While it is clear that NFTs may be considered works of art. But it is unclear whether or not an NFT can be considered a collectible. Whether or not an NFT can be considered a collectible for tax purposes can make a big difference to the investor’s tax bill. This is because the maximum long term capital gains rate on gains from the sale of most assets is 20 percent. On the other hand, the maximum rate on gains from the sale of collectibles is 28 percent. Whether or not NFTs can be taxed as a collectible will need to be determined on a case-by-case basis.
The Reporting of Cryptocurrency on an Individual Income Tax Return
The IRS is starting to track and enforce cryptocurrency compliance regarding virtual currency transactions. The individual 1040 tax returns require taxpayers to answer yes or no questions regarding whether the taxpayer was involved in the transfer of virtual currencies. Capital gains and losses are reported on Form 8949 and on Schedule D of the Form 1040 for individual taxpayers. Ordinary income received from cryptocurrency is reported on Schedule 1 of Form 1040 for individuals. Any virtual currency received as compensation for services or disposed of in a sale to customers in a trade or business is reported as the individual would report other income of the same type (i.e., on Form W-2 for wages or investory or services on Schedule C).
Foreign Informational Return Reporting Consideration
It has been somewhat ambiguous whether virtual currency transactions are required to be reported on Form 8938 or FinCen Form 114 (also known as “FBAR”). These forms are required for the disclosure of foreign bank accounts or assets.
Taxpayers with specified foreign assets that exceed certain thresholds must report those assets to the IRS on Form 8938, Statement of Specified Foreign Financial Assets, which is filed with an income tax return. A specified foreign financial asset includes financial accounts maintained by a foreign financial institution or the following foreign financial assets if they are held for investment and not held in an account maintained by a financial institution: 1) stock or securities issued by someone that is not a U.S. person (including stock or securities issued by a person organized under the laws of a U.S. possession); 2) any interest in a foreign entity; and 3) any financial instrument or contract that has an issuer or counterparty that is not a U.S. person. Cryptocurrency cannot be considered stock, security, or an interest in a foreign corporation. However, cryptocurrency may be considered a “financial instrument or contract that has an issuer or counterparty that is not a U.S. person.” Virtual currencies like Bitcoin and Ethereum only exist as digital representations of value. However, cryptocurrency has also been referred to as “smart contracts.” This is because virtual currencies are legally enforceable contracts which translate programming code into written blockchain for autonomous execution and enforcement. Under this broad and expanding definition of cryptocurrency, many U.S. cypocurreny will likely have an 8938 filing requirement.
FBARs are used to report a U.S. person’s financial accounts in a foreign country. Under the current FBAR regulations, a U.S. person is not required to report cryptocurrency on an FBAR. However, on December 30, 2020, the Financial Crimes Enforcement Network (“FinCEN”) published the following guidance:
“Currency, the Report of Foreign Bank and Financial Accounts (FBAR) regulations do not define a foreign account holding virtual currency as a type of reportable account. (See 31 C.F.R. 1010.350(c)). For that reason, at this time, a foreign account holding virtual currency is not reportable on the FBAR (unless it is a reportable account under 31 C.F.R. 1010.350 because it holds reportable assets besides virtual currency). However, FinCEN intends to propose to amend the regulations implementing the Bank Secrecy Act (BSA) regarding reports of foreign financial accounts (FBAR) to include virtual currency as a type of reportable account under 31 C.F.R. 1010.350.” See FinCEN Notice 2020-2.
With FinCEN providing notice that cryptocurrency reporting change is coming for purposes of the FBAR, virtual currency holders must understand that their filing requirements with the IRS will likely increase in the very near future.
Overall, cryptocurrency is still an emerging asset class with a largely undefined tax framework. As a result, little authoritative guidance is available for investors with respect to basis tracking. Thus, cryptocurrency investors should adopt a method that is both thorough and consistent on what is known about the current law, until further guidance becomes available. Investors should seek guidance from an experienced tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony Diosdi focuses a part of his practice on criminal tax enforcement, broad-based civil tax compliance and white collar matters generally. He also advises clients on the IRS voluntary disclosure program, with particular focus on disclosure related to offshore banking accounts.
Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.