Compounding a disastrous year for Bitcoin and other cryptocurrencies: The IRS proposes a controversial new question about digital assets

The Internal Revenue Service could have a potential question about your crypto investments and what’s taxable, according to a major accountants association.

For two years, the IRS has been asking whether taxpayers have bought or sold cryptocurrencies on the main “Form 1040” document that taxpayers file on their federal income taxes. The survey also asks about other potential crypto-related tax events. It’s a yes or no question that taxpayers can’t leave blank.

Last year, Form 1040 asked, “Did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” (The wording differed slightly from the language that appeared on Form 1040 last year. The question first appeared in tax year 2019, on Schedule 1.)

The prominent placement is a nod to the IRS’s increasingly intense focus on ensuring that cryptocurrency investors fully meet their tax obligations.

Fast-forward to next year’s tax returns: The IRS proposed a draft question asking on next year’s Form 1040: “At any time during 2022: (a) did you receive (as a reward, award, or compensation)? or (b) sell, trade, give away or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”

For 2023, the IRS suggests asking: “Anytime during 2022: (a) received (as a reward, prize, or compensation); or (b) sold, exchanged, given, or otherwise disposed of a digital asset (or an economic interest in a digital asset)?’

However, after the IRS revealed the proposed wording of this question ahead of the 2023 tax season, the American Institute of CPAs recommended that the IRS get out its pencils and erasers. The IRS needs to clarify the issue to avoid taxpayer confusion, the agency said in its comment letter.

In general, capital gains taxes will affect sales, currencies traded, the acquisition of cryptocurrencies through mining, and other scenarios. But buying cryptocurrency and then holding it has not is counted as a taxable event. When jobs pay in cryptocurrency, for example, they are typically treated as wages subject to employment tax, the IRS says.

In some ways, the newer version of the question is an improvement, said Annette Nellen, a San Jose State University tax professor who chairs the AICPA’s virtual currency task force. But including the phrase ‘digital asset’ will create new problems and new confusion,” he said.

In addition to cryptocurrencies such as Bitcoin BTCUSD,
-0.21%
or Ethereum ETHE,
+0.26%
ETH USD,
+0.30%,
The use of a phrase like “digital asset” raised questions about whether the IRS was also asking about non-tradeable tokens (NFTs) and game currency like Fortnite’s V-Bucks or the Robux offered on Roblox RBLX.
-1.48%,
AICPA noted.

The IRS has previously removed V-Bucks and Robux as examples of virtual currency that can be converted into real-world money. But creating, buying and selling NFTs can have tax implications.

After the IRS unveiled proposed wording for a new question about digital assets ahead of the 2023 tax season, the American Institute of CPAs advised the tax agency to get out its pencils and erasers.

So what is the solution? The better approach would be to ask whether taxpayers during the year had “a taxable event involving virtual currency” and then provide guidance on what that means, the AICPA said in its comment letter.

Those instructions, he added, should clarify that an individual user does not need to check “yes” if the child or dependent had their own cryptocurrency-related tax events that generated income below the deposit limits.

The wording of the tax documents may sound like dry semantics, but it underscores how much is still being determined about cryptocurrencies, taxes — and the public’s continued need to understand how the two interact.

The AICPA’s comment letter wants the IRS to stick with the term “virtual currency” instead of “digital asset” for now. But still, he notes, there are variations in how the IRS formally and informally defines “virtual currency” in its guidance and directives.

One reason investors need to understand the tax rules now is because it can help offset their losses in 2022. Investors can use capital losses to offset their gains. If losses exceed gains — and this can be the unfortunate case for some hard-hit cryptocurrency investors — a taxpayer can claim up to $3,000 in capital losses. Any remaining losses can be carried forward to future tax years.

Investors can use capital losses to offset their gains. If losses exceed gains — and this can be the unfortunate case for some hard-hit cryptocurrency investors — a taxpayer can claim up to $3,000 in capital losses.

Bitcoin BTCUSD,
-0.21%
was trading just above $20,000 on Thursday, down nearly 57% since the start of the year. Ethereum ETHUSD,
+0.30%
is down more than 57% year-to-date.

Nearly two in ten US adults said they owned cryptocurrencies as of August, according to an ongoing Morning Consult poll. 18% in August is about the same as the start of the year.

Matt Metras of MDM Financial Services in Rochester, New York has a more favorable view of the question the IRS is trying to ask. “It’s not perfect, but it’s better than last year,” said Metras, who specializes in tax preparation for cryptocurrency holders. “The use of digital elements is more comprehensive,” he said.

However, Metras doesn’t know if there will ever be a crystal clear, concise and perfectly worded way for the IRS to quiz cryptocurrency holdings. The landscape continues to change so quickly, he noted.

The agency thinks about “readability and the information that needs to be collected” when it puts new language on a tax form, said Michael Kramarz, director of Kaufman Rossin’s tax services consulting group.

“A taxpayer’s response to a request for information on a tax form is only as good as the question asked. If a taxpayer can’t understand the language on a tax form, the IRS won’t be able to gather the type and scope of information they’re looking for,” said Kramarz, a former IRS attorney.

The IRS will consider feedback from tax professionals and the general public as it finalizes the wording of tax documents, Kramarz noted. They can submit comments here.

Typically, final tax forms start going out around November and December, Nellen said. The IRS declined to comment.

According to Metras, “There is a lot of confusion among the general public about what is reportable and what is not,” with cryptocurrencies. As a result, “there are people out there dealing with this who aren’t sure about the question.”

Now cryptocurrency owners and tax professionals will have to wait for the final wording from the IRS. “How it ends up is always a fun surprise,” Metras said.

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