Throughout 2021, the world has seen the rise, fall, and evolution of virtual currencies and assets supported and based upon blockchain technology. Collectively, these assets are referred to as “digital assets.” The most widely recognized digital asset, Bitcoin (BTC), hit record highs in January, February, March, and April, with its peak being just over $64,000 per coin in April. Also in April, the world’s largest trading platform for virtual currencies, Coinbase, went public with the completion of its IPO.
Traditional trading cards have taken a new digital spin by being packaged and sold as non-fungible tokens (NFTs) through websites like the NBA’s Top Shop. As an NFT, these select highlights capture brief moments in time, and are only issued in limited quantities. Digital aspects of the NFT, such as the first and last issuance of the NFT or the NFT containing the player’s jersey number, typically increase its value in the market. While many NFTs are sold in packs like traditional playing cards, the days of physical cards packed alongside a package of bubble gum or cigarettes may be long gone.
Other digital mediums are also being converted into NFTs and sold as collectibles across the world. Some of the more notable such items from 2021 include a collection of Beeple’s artwork that sold for $69M and the popular Nyan Cat gif that sold for $560,000.
As virtual currency grows in popularity, the IRS is expanding its examination of these assets and transactions. The IRS sees this space as one where under-reporting is likely commonplace. Beginning in 2019, the IRS began requiring taxpayers to note if they had disposed of virtual assets. This question will continue to be on the 2021 Form 1040 and the front page of the tax return.
Recent legislation in DC, if passed, may have sweeping consequences for businesses and brokers using digital assets in their daily operations. Currently, there is a bill that could eliminate wash rule exceptions for cryptocurrencies.
Until more information is available, we’ve highlighted a few considerations related to virtual assets for 2021 tax planning.
Tax Bracket Management – Wash Sale Rules Do Not Apply
Investors should look to manage capital gains by harvesting losses. For traditional securities, you cannot recognize a loss on the sale of a position if you turn around and substantially purchase an identical security within 30 days of the sale; this is called a wash sale. Since wash sales rules do not apply, you may sell a loss position to offset recognized gains from earlier in the year and have a smaller net taxable gain between the transactions.
Since digital assets are classified as property for tax purposes, wash sale rules do not apply when selling positions at a loss. This can be particularly helpful for virtual currencies like Bitcoin, which see large volatile fluctuations in a year.
Note: the proposed Build Back Better Act proposed by Congress on September 13, 2021, will make this strategy moot for transactions occurring after September 13, 2021 and may require additional computation in determining realized gains and losses as this proposal specifically identifies digital assets as subject to wash sale rules if passed.
Foreign Account Reporting Concerns
Determine where virtual assets are located, and if any are in foreign accounts. Some of the brokerage houses physically storing digital assets are outside the US and may fall under certain foreign income or account reporting rules. This area of regulatory compliance may become complicated quickly, and penalties associated with non-compliance are steep.
As of right now, the Financial Crimes Enforcement Network (FinCEN) has stated that virtual currencies are not currently classified as reportable assets for the purposes of the Foreign Bank and Financial Accounts (FBAR), but has indicated they are looking at changing this in the future. As a result, additional foreign reporting may apply depending on the maximum value of your account during the year as of December 31, 2021.
Character of Income – Capital Gains or Ordinary Income (and/or Self-Employment)
Not all income from the disposition of digital assets is classified as capital gains. For many taxpayers, their transactions with digital assets will only be from the purchase or disposition of the asset. However, some individuals generate business, investment, or other income through their digital assets.
Those who mine cryptocurrencies and support the blockchain through proof of stake or proof of work computations may have business income subject to self-employment taxes and ordinary income taxes. Additionally, if you received additional assets from a fork in a blockchain, this is considered income when you control the assets. As blockchain technology evolves, new applications and protocols are being developed to host various decentralized financing applications, potentially leading to the rise of decidedly complicated transactions.
Record-Keeping — A Necessary Focus for any Investor
Since the number of transactions related to digital assets can be numerous, and transfers between various wallets only add to the complexity, it is vital to maintain transaction records.
Many large platforms provide these tools already. However, as different providers transfer assets between wallets, it is easy to lose track of nontaxable transfers and over-report taxable gains in a year. Many third-party sites offer programs to track and compute unrealized gains and losses and manage transfers between wallets. By using these types of tools, you can evaluate your positions and make informed decisions.
Exploring Cryptocurrencies with Aldrich
Virtual currencies represent an exciting new foray in investing. Innovative technology makes digital assets more accessible and is likely to continue making headlines. If you’re interested in digital assets or have questions about your tax liability, please reach out to your Aldrich Advisor.
This article was written with the most updated information as of October 1, 2021.
Meet the Author
Matthew Kanter, CPA, CFP®
Aldrich CPAs + Advisors LLP
Matthew Kanter joined the firm in 2017 with five years of experience working with individuals and small businesses at a small accounting firm in the Portland, Oregon area. Here at Aldrich, Matthew assists with tax compliance and planning for individuals, high net-worth clients, and estates and trusts. Matthew enjoys empowering his clients to focus on…
- Certified Public Accountant
- High-net-worth individuals
- Strategic tax planning and compliance