What is a digital asset?
In the broadest sense, a digital asset is an item that is created and stored digitally, has value, has established ownership, and is discoverable. The Treasury Department has added to the definition that a digital asset must be recorded on a cryptographically secured distributed ledger or any similar technology. The IRS includes “cryptocurrency” and “virtual currency” as digital assets.
Examples of digital assets include (but are not limited to):
- Convertible virtual currency and cryptocurrency (think Bitcoin);
- Stablecoins (think Tether); and
- Non-fungible tokens (NFTs) (think CryptoPunks).
What is virtual currency?
Virtual currency is a digital representation of value other than a representation of the U.S. dollar or a foreign currency (“real currency”). Virtual currency is used as a unit of account, a store of value, or a medium of exchange.
What is cryptocurrency?
Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions. Cryptocurrencies use a decentralized system to record transactions and issue new units.
Bitcoin is a cryptocurrency, because it uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction. A transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction, where individuals can engage directly with each other without necessarily using a trusted third party like a cryptocurrency exchange.
What is an NFT?
An NFT is a ‘non-fungible token’. Non-fungible means that something is unique and can’t be replaced. Every NFT contains a digital signature, which makes each one unique. By contrast, a fungible item is one whose individual units are essentially interchangeable, and each of whose parts are indistinguishable from any other part. Physical currency is fungible, which means a $100 note is indistinguishable from and has the same value as any other $100 note in circulation. An NFT can represent both a digital asset such as an image, but it can also track real-world assets, such as a house, a car, or a song.
Why are digital asset transactions taxable?
Income is generally taxable regardless of its source. As such, digital asset transactions are taxable just like ‘traditional’ transactions involving money for goods or services, or an exchange of property for other property or services. Digital assets are treated as property by the IRS and general tax principles that apply to property transactions will apply to a transaction involving a digital asset.
How are digital asset transactions taxed?
In general, individuals who transact with digital assets, including buying, selling or exchanging digital assets, hold the digital assets as capital assets and the sale or exchange results in capital gain or capital loss. However, digital assets received as compensation for services is treated the same as wages and results in ordinary income to the recipient who then holds the digital asset as a capital asset.
The following examples illustrate several common transactions involving digital assets:
- Sales: When you sell a digital asset, it is generally a capital asset, and you must report the transaction along with any capital gain or loss on the sale.
- Example: If Mary purchased 5 Bitcoins for $50,000 in April and sold all of her Bitcoins in July for $52,000, she would have short-term capital gain of $2,000 (the sales price less the purchase price). If Mary sold the Bitcoins for $48,000, she would have a short-term capital loss on the sale, subject to any limitations on capital loss deductions. It is important to note that Mary must have sold her coins to recognize the loss; she may not report a loss merely because the coins she holds declined in value.
- Exchanges: If you exchange digital asset held as a capital asset for services or other property, including goods or another digital asset, you must report the transaction and any capital gain or loss resulting from the difference between the fair market value of the property or service you received and the basis of the property given up.
- Example: If Bill buys 5 Bitcoins for $50,000 in April and exchanges them for another virtual currency in June worth $40,000 at the date and time of the exchange, Bill would report a $10,000 short-term capital loss on the transaction. In this case, Bill would have to look at his other capital losses and could potentially be limited in how much he could deduct in the current year. Likewise, if the exchanged virtual currency was worth $60,000 instead of $40,000, Bill would report a $10,000 short-term capital gain on the transaction.
- Earnings: When you receive property, including a digital asset, in exchange for performing services, whether or not you perform the services as an employee, you must report the earnings as ordinary income. Compensation for services is reported and taxed the same regardless of how the compensation is received (dollars, virtual currencies, property, or other services). If you receive a digital asset in return for providing services as an employee, it’s considered wages and is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported by your employer on Form W-2, Wage and Tax Statement, like traditional wages paid in U.S. dollars. If you receive a digital asset in return for providing services and are not an employee of the payor, you are self-employed, and may be considered an independent contractor.
- Example: If Deng receives 10 Bitcoin worth $100,000 for providing services as an employee, he should report this as “wages” on his income tax return. If Deng is not an employee, the compensation is reported on Schedule 1 or Schedule C. Deng must report this income on his income tax return regardless of whether or not he receives a Form W-2, Form 1099-MISC, or other information return.
- Hard forks: A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency in addition to the legacy cryptocurrency. If your cryptocurrency went through a hard fork but you did not receive any new cryptocurrency, you don’t have taxable income.
- Example: Maria holds 10 units of cryptocurrency A that has a hard fork after which she also has 10 units of cryptocurrency B. Regardless of how she receives the new cryptocurrency B, she has income. If the 10 units of cryptocurrency B are worth $50 at the date and time she receives them, Maria will have taxable income of $50 that she must report in the year she receives the cryptocurrency B.
- Theft: If your digital asset investment was stolen, then the theft loss rules apply to the year you became aware of the theft. (See Chief Counsel Advice (CCA) 202302011 and Tax Topic No. 515 Casualty, Disaster, and Theft Losses for more information.) The theft must meet your local jurisdiction’s definition of theft and you must include any consideration you received for the theft when calculating your loss (or gain). If the theft results in a net loss, the loss is an ordinary loss and is not subject to the miscellaneous itemized deduction limitations.
- Bankruptcy or Frozen Account: Although some digital assets lost a significant amount of their value during 2022, you cannot claim a loss from this decrease on your tax return until there is a closed and completed transaction, such as a sale or exchange. If your digital asset investment account is frozen or your digital assets are tied up in bankruptcy proceedings, you can’t claim a taxable loss because you don’t have a closed and completed transaction. Once your account has been unfrozen or the bankruptcy proceedings completed, you will have to reassess your situation. If your digital assets and your ownership of them have remained intact, and they have any value, then you don’t have a recognizable loss. If you received a settlement (regardless how small) from the bankruptcy proceedings in exchange for your digital assets, this is considered a sale and you should report your capital loss (or gain) on Form 8949 for the year you received the settlement. If you received nothing from the bankruptcy settlement, neither money nor your digital assets, then your digital asset investment is considered worthless and different rules apply.
- Worthless or Abandoned: Unlike a sale of a digital asset investment that results in capital gain or loss, the loss from your digital asset investment becoming completely worthless is an ordinary loss. You should note that the asset must be completely worthless, not nearly worthless, for this loss to be recognized. An ordinary loss from a worthless or abandoned investment is a miscellaneous itemized deduction in the year of worthlessness/abandonment but is not deductible on your tax return because the Tax Cuts and Jobs Act of 2017 provides that an individual’s miscellaneous itemized deductions are not deductible in 2018 through 2025.
For more information on the tax treatment of property transactions, see Publication 544, Sales and Other Dispositions of Assets.
What digital asset transactions are not taxable?
Generally, the same rules that apply to other property apply to digital assets. Not all property transactions are taxable. For example, the following transactions are not taxable:
- Transactions with yourself. If you transfer virtual currency from a wallet, address, or account belonging to you, to another wallet, address, or account that also belongs to you, the transfer is a non-taxable event, even if you receive an information return reporting the transfer.
- Bona fide gifts. If you receive a digital asset as a bona fide gift, the gift is not taxable. You will report any income or loss when you sell, exchange, or otherwise dispose of the digital asset. If you are the one giving the digital asset, you may need to report the gift on a gift tax return. See the instructions for Form 709 for more information.
- Charitable donations. If you donate a digital asset to a charitable organization described in Internal Revenue Code Section 170(c), you will not report income, gain, or loss from the donation. You may, however, be entitled to claim a contribution deduction on your tax return in the year you made the donation.
- Soft forks. A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you.
Where are digital asset transactions reported?
Transactions involving digital assets are generally reported on the same tax forms as transactions in other property.
- Checkbox on page 1 of Form 1040, U.S. Individual Income Tax Return, or Form 1040-SR, U.S. Tax Return for Seniors. Beginning in 2020, if you engage in certain digital asset transactions, check the “Yes” box next to the question on digital asset (formerly virtual currency) on page 1 of Form 1040 or Form 1040-SR. See the Instructions for Form 1040, U.S. Individual Income Tax Return/Form 1040S U.S. Individual Income Tax Return for Seniors for more information.
- Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D (Form 1040 or 1040-SR), Capital Gains and Losses. You must report most sales and other capital transactions on Form 8949, and then summarize capital gains and deductible capital losses on Schedule D.
- Form 1040 series or Form 1040 Schedule 1, Additional Income and Adjustments to Income. You must report ordinary income from digital assets on Form 1040, U.S. Individual Tax Return, Form 1040-SS, U.S. Self-Employment Tax Return (Including the Additional Child Tax Credit for Bone Fide Residents of Puerto Rico), Form 1040-NR, U.S. Nonresident Alien Income Tax Return, or Form 1040, Schedule 1, Additional Income and Adjustments to Income, as applicable.
What records do I need to maintain regarding my digital asset transactions?
The Internal Revenue Code and regulations require taxpayers to maintain records that are sufficient to establish the positions taken on their federal tax returns. You should therefore maintain records for at least three years after reporting any taxable event or have other reporting requirements, even if they’re not immediately taxable, documenting purchases, receipts, sales, exchanges, or other dispositions of your digital asset and the fair market value of any property or service you received in exchange for a digital asset
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