Last Updated: August 25, 2020
This article was originally published on Forbes by Shehan Chandrasekera on December 20, 2019
2019 has been an eventful year for cryptocurrency taxes and IRS activity. Five years after the the issuance of Notice 2014-21, the IRS released 43 Q&As elaborating on the original guidance along with the Rev. Rul. 2019-24, addressing cryptocurrency forks.
In December 2019, the IRS also finalized the 2019 Schedule 1 of Form 1040. Starting with the 2020 tax season, the first question on this schedule will ask all US taxpayers “At anytime during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” I will refer to this broad question as the “crypto question” throughout this series.
With an inclusion of this type of question, crypto tax compliance — once a niche subject — is headed mainstream. As a result, both taxpayers and tax practitioners must know how to properly address this question going forward.
This six part series will take a deep dive into the crypto question by explaining the background behind its inclusion and analyzing tax ramifications for each segment (“receive”, “sell”, “send”, “exchange”, and “financial interest”) in detail.
Background Behind The “Crypto Question”
Increase Compliance & Tax Revenue
According to Michael Desmond, the Chief Counsel of the IRS, the service should be receiving roughly 12 million tax returns with some sort of crypto affiliation. However, the service is receiving far fewer than that. By adding the crypto questions, the IRS believes that the voluntary compliance will increase in future years. Clearly, the question will alert and educate taxpayers to rethink about their crypto activity and determine if they have any taxable transactions during the year. Moreover, tax practitioners asking their clients this question during tax preparation will also lead to an uptick in compliance.
For those of you who are tax geeks, this question may remind you of the question on Schedule B Part III. The question on Line 7a asks taxpayers “at any time during 2019, did you have a financial interest in or signature authority over a financial account (such as a bank account, securities account, or brokerage account) located in a foreign country?” Since the addition of this question, the IRS has seen a significant improvement in foreign reporting. The service is expected to see the same success with the addition of crypto question on Schedule 1.
The crypto question is also meant to help the IRS with data gathering. Right now, there is no solid matching mechanism to capture US taxpayers who trade cryptocurrencies. Exchanges are only required to issue Form 1099-K if the user has gross payments that exceed $20,000 and more than 200 transactions in a crypto exchange. First off, Form 1099-K cannot actually be used to calculate cryptocurrency taxes, but beyond that, there is only a small fraction of US cryptocurrency users who would even be eligible to receive this form. Most users who do not receive 1099-Ks may incorrectly think that there is no cryptocurrency reporting obligation whatsoever.
Unlike stock brokerages, cryptocurrency exchanges face a deeper issue when it comes to reporting cryptocurrency transactions. In the established equities world, brokerages can simply produce a 1099-B with the basis of each asset and the associated capital gains at disposal. In the cryptocurrency world however, users commonly use multiple exchanges, transfer assets between them, and self custody their assets on local wallets (held off of any exchange). This means that exchanges cannot produce a form similar to a 1099-B for most taxpayers, because they cannot see the holistic picture of users’ cryptocurrency activity.
Until regulators find an alternative matching solution which is compatible in the crypto space, just asking the taxpayers whether they have any crypto transaction is a simple way to gather data. Users trying to be tax compliant in the meantime have to resort to working with tax professionals and/or using cryptocurrency tax software.
Additionally, asking the all-inclusive crypto question is a great way to spot and potentially track long time HODLers of crypto assets. For example, assume Jennet purchased 100 bitcoins in 2010 for $10,000 ($100 x 100) at $100 per bitcoin. Each year, Jennet’s position increased in value. However, there was no tax reporting nor obligation because she did not dispose her position. As a matter of fact, the IRS would not even know about Jennet’s ownership of her bitcoin position until she disposes.
However, this situation is changing effective January 1, 2019. Assume during 2019 Jennet transferred some bitcoins from her original wallet to another wallet she controls. This would require her to check “yes” on the crypto question, even though there is no taxable event. Without having a question like this, tax authorities have no way to know about your positions with large unrealized gains. Likewise, the service will use this question to gather data about both taxable and non-taxable events related to cryptocurrencies.
Best Practice Is To Answer The Crypto Question
According to the draft instructions for 2019 Schedule 1, if you have any crypto affiliation covered by the question, you must check “yes”, even if you do not have anything to report on Part I and Part II of Schedule 1. Leaving this question blank is not advised. As with the example above, there may be situations where the taxpayer will check “yes” but there will not be any reportable transactions on any other tax forms. This is completely fine!
The next posts of this series will analyze each category of cryptocurrency transactions (receive, sell, send, exchange, financial interest) covered by the crypto question. They will also dive deep into taxable and non-taxable events, and illustrate how to apply tax rules given the limited IRS guidance we have.
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Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.