Avoiding the Top 10 Cryptocurrency Tax Traps
With so many rules and nuances to consider within the cryptocurrency space, it’s no surprise that many tax clients fall victim to reporting mistakes. To prevent your clients from pointing the blame finger at you, here’s what to look out for.
The number of U.S. taxpayers investing in cryptocurrencies is rapidly growing. As of summer 2022, 18 percent of Americans had invested in different cryptocurrencies — a 125-percent jump from summer 2020, according to Finbold.
Even though more Americans are investing in cryptocurrencies, many tax clients are still unaware of their reporting responsibilities, and even among those who are aware, there’s often confusion on how to do so accurately as regulatory guidance has been slow to keep up with the market. This puts extra pressure on CPAs to make sure their clients accurately track, report, and pay taxes on their eligible cryptocurrency transactions.
Guinevere “Gwen” Moore, managing member of Chicago-based Moore Tax Law Group, says there’s a fundamental misunderstanding from her clients about their cryptocurrency reporting obligations, and she further warns that CPAs need to work extra hard to protect themselves in this growing environment: “If something goes wrong, we all know the client is going to point their finger straight at their CPA.”
To help clients navigate this space, here are the top 10 cryptocurrency tax traps to avoid.
1. Not Reporting Cryptocurrency Activity
There’s only a few scenarios where you don’t have to report cryptocurrency activity to the IRS: when the only action you engaged in was purchasing a cryptocurrency with U.S. dollars, holding it, or transferring it from one wallet to another that you possess. If your cryptocurrency activity extends beyond these scenarios, then there are IRS reporting requirements.
“I increasingly have clients with cryptocurrency reporting issues, and those typically stem from them not reporting cryptocurrency at all, or from not understanding that cryptocurrency has to be reported on a transactional basis,” Moore explains. “Whatever you do, make sure there’s a good record of the process that your client went through to determine how to report it.”
2. Failing to Prepare and Maintain Adequate Records
Missing data and information are one of the most difficult issues tax professionals face when handling clients’ cryptocurrency accounts.
“Clients rarely keep records or even have an idea of everything they’ve done related to it,” says Justin McCormick, senior associate in the digital assets group at Founders CPA, a Chicago-based firm. “It’s often like trying to put a puzzle together.”
Andrew Gordon, CPA, managing attorney with Gordon Law Group Ltd. in Skokie, Ill., runs into the same problem on a regular basis.
“Data collection is probably 75 percent of the process,” Gordon says. Most cryptocurrency platforms don’t issue tax forms, but the obligation for taxpayers to report their transactions still exists. This puts an extra burden on taxpayers to either access or create their transaction reports, provide them to their CPA, and remember everything they did. “Very often, clients will lose track of what cryptocurrency they were using and when they were using it, and that makes things more difficult,” Gordon explains. Despite these challenges, Gordon points out that the blockchain technology that cryptocurrency transactions rely on is “this record of everything that’s happened and it’s immutable. It doesn’t go away, so we can typically identify transactions to a certain address and use the information that we do have to help identify any missing information.”
Encouraging your clients to utilize software programs can help. For smaller cryptocurrency investors, creating a simple spreadsheet tracking their cryptocurrency transactions is likely enough. For others, it may be helpful to use a cryptocurrency tracking app or program, like CoinTracker.
Christopher Lazzaro, CPA, crypto tax analyst at CoinTracker says the company’s app is helpful because it “allows you to see what you paid for the crypto asset and what you sold it for. It’s a computer program, so you might need to manually address gaps on obscure tokens, but it’s generally automated and a great tool to help you maintain your records and be able to prove transactions.”
3. Failing to Properly Calculate Capital Gains and Losses
Much like buying and selling stocks, when your clients sell their cryptocurrencies, they should recognize a capital gain or loss based on their cost basis and selling prices.
Given the wild swings in cryptocurrency prices, Moore emphasizes that taxpayers will likely be eager to report any cryptocurrency losses to the IRS, as they can potentially offset the entirety of the tax consequences created by any realized capital gains.
In the event of lost cryptocurrency resulting from a corporate collapse, Gordon says taxpayers can’t claim a loss until that loss is certain. Meaning, a bankruptcy court adjudicates the case.
“Then the question is, is this a tax deduction? Is this a capital loss? When can you realize it?” Gordon says. “Historically we’ve seen companies go bankrupt on other exchanges and still be able to pay out their holders.” One example is Mt. Gox, one of the largest cryptocurrency exchanges that launched in 2010 until its collapse in 2014. “A loss isn’t a loss until it’s final. With these types of losses, people often feel that they’ve lost before that’s actually the case,” Gordon stresses.
4. Using the Wrong Forms to Report Cryptocurrency Transactions
Information reporting requirements arise when a taxpayer starts to use cryptocurrency in exchanges, such as trading one cryptocurrency for other cryptocurrencies, or purchasing services and goods with cryptocurrency.
Where can CPAs find this information? Right now, Moore says the best resource is the IRS’ FAQ on virtual currency transactions.
She notes, “If you read through those FAQs, they’ll either give you the answer to nine questions out of 10 that you’re going to have, or they’ll give you the next best place to go.” Even if you can’t reach the right answer, Moore believes you’re likely going to get to a very defensible position from an IRS adjustment standpoint and from a malpractice standpoint.
Gordon points out that the tax software that currently exists on the market meets the basic requirements for most basic cryptocurrency transactions. However, as soon as clients start to have more complex activity, for instance in decentralized finance, it’s usually a few years ahead of the software’s capability.
Gordon’s firm uses software from ZenLedger and BitcoinTaxes, but admits the accountants are left doing most of the work manually. “I would caution reliance on software because it’s in its early stages,” he says. “It’s a very new space that has a lot of nuances. Imagine designing tax software but there’s all these variables. The problem is cryptocurrency changes every year—new functions and transactions, new terms and definitions that the software has to be updated for, and often by the time it is, the tax return was due.”
5. Improperly Reporting Cryptocurrency Received as Earned Income
Generally, the IRS treats cryptocurrency as property, meaning that when you buy, sell, or exchange it, this counts as a taxable event and typically results in either a capital gain or loss. Taxpayers need to use Form 8949 for reporting cryptocurrency gains and losses when the cryptocurrency is treated as property. When you earn income from cryptocurrency activities, or receive cryptocurrency as compensation, it’s treated as ordinary income and should be reported on Form 1040.
6. Using the Like-Kind Exchange Exception
“Like-kind exchanges don’t apply to cryptocurrency,” Lazzaro says.
The Internal Revenue Code has traditionally permitted investors to exchange real property used for business or held for investment purposes for other business or investment property of the same type, but the IRS released a memorandum clarifying that cryptocurrency exchanges aren’t included in the like-kind exchange exception. The memo addressed Bitcoin, Ether, and Litecoin specifically, but it likely applies to all cryptocurrencies. However, it doesn’t necessarily apply to transactions that occurred before Jan. 1, 2018. The IRS stated that like-kind exchange treatment to cryptocurrency transactions prior to 2018 are left in a “grey area that will be decided on a case-by-case basis.”
7. Failing to Report Cryptocurrency Exchanged for Goods and Services
More retailers are beginning to accept cryptocurrencies as payment for their goods and services, but anytime you use cryptocurrency for payments, it’s a taxable event.
“The IRS is very clear about that,” Lazzaro notes. “Whatever the fair market value of the cryptocurrency used was at the time you spent it, that’s going to determine your proceeds on that sale.”
8. Improperly Reporting Cryptocurrency From Airdrops, Forks and Splits
Airdrops, forks and splits are some of the more complex aspects of cryptocurrency tax reporting. According to the IRS:
- An airdrop is a form of cryptocurrency marketing in which a developer distributes new tokens to potential users and investors, often for free, to generate attention and build a loyal base of followers.
- A fork is an update (whether minor or major) to the blockchain protocols on which virtual currency transactions are recorded.
- A hard fork is when the blockchain coin/token permanently splits into two, leaving investors with two differently valued, incompatible types of blockchains and tokens.
Moore warns that cryptocurrency holders might’ve received additional coins or tokens from these taxable events without understanding where they came from.
According to a July 2021 IRS notice, recipients must treat newly received cryptocurrency as ordinary income, even if they didn’t have any control over the fork or airdrop, and didn’t intentionally plan for or purchase new coins. The recipient’s basis in the newly acquired cryptocurrency is the fair market value at the time it was received.
9. Failing to Report Cryptocurrency-to-Cryptocurrency Transactions
As mentioned before, cryptocurrency is treated as property in most cases for federal tax purposes. Taxpayers who exchange one cryptocurrency that’s held as a capital asset for another cryptocurrency are exchanging property for property and must recognize a capital gain or loss.
“It’s becoming better understood, but for a while most people didn’t realize trading one cryptocurrency for another was a taxable event,” Lazzaro notes. “For example, people weren’t realizing that switching their Bitcoin to Ethereum or some other token was taxable.”
10. Failing to Take Proper Steps in the Event of Death or Disability
Cryptocurrencies, if not held through a cryptocurrency exchange or broker, are often stored on private digital wallets with unique key codes to access them. Therefore, estate planning is crucial to ensure the information needed to access and take ownership of the cryptocurrency isn’t lost in the event of a death or disability. Simply advising a client to share this information with a trusted spouse or heir may be sufficient to some, but more formal processes may be required depending on where and how the cryptocurrency is stored and how concerned the owner is about security.
Sharing your private keys with another person leaves you vulnerable to that person using your keys to create a wallet controlled by them on another computer or device, which could give them access to all your cryptocurrency, Lazzaro warns.
Moore says some exchanges can allow the family of a deceased investor to gain access through a verification process. Another method she notes is to establish a “time-locked transition,” where one can designate a specific time to transfer their cryptocurrency to someone else.
In some ways, cryptocurrency can be seen as having its own language and accounting system, with so many shifting rules and nuances as regulatory bodies converge on the space. “We work with many CPAs that don’t yet know this side of the practice, and there’s nothing wrong with that. It’s quite a specialized focus,” Gordon says. “If you walk past some of our staff reading the blockchain, it looks like they’re looking at something out of “The Matrix.” Not everyone wants to do that or wants to keep up on all those changes.”
However, there are opportunities for those that do want to truly engage in this space. Lazzaro, who’s been in public accounting for nearly two decades, has completely immersed himself in the cryptocurrency world for the last three years. “I started doing all these other taxable transactions, like staking, looking at the decentralized exchanges, providing liquidity, and buying NFTs so I could understand it and talk to my clients about it,” Lazzaro says. “I felt, if I was able to do it, I’d be a better advisor.”
Importantly, Moore urges CPAs to be direct with their clients: “Don’t be afraid to ask questions and push back to make sure that you fully understand your clients’ cryptocurrency transactions and what is and isn’t being reported by them. It’s really important that you have a good record of having said out loud whether you’re comfortable with their activity, understand their transactions, or if additional information is needed.”
Remember, if the IRS comes to audit a client, you can pretty much guarantee that they’re going to say, “It wasn’t me,” and point their finger right at their CPA.
Kasia White is a freelance writer who specializes in profiling small businesses, covering the musical products industry and interviewing leaders of globally renowned companies.
Reprinted courtesy of Insight, the magazine of the Illinois CPA Society. For the latest issue, visit www.icpas.org/insight.