By Pat Larsen, CEO of ZenLedgertop crypto tax and forensic accounting platform
Crypto tax compliance is a major topic of conversation this year, but many are still struggling to keep up with regulations as the space evolves. We expect to see overall compliance increase rapidly over the next few years as the IRS continues to issue warning letters and conduct audits. We also expect there to be a comprehensive crypto regulation and taxation bill passed by Congress and enforced by the Treasury Dept. We are currently in a bit of a limbo area where there are not comprehensive laws and only a bit of guidance from the IRS, so accountants, corporations and individuals have to make a lot of judgment calls. Here’s some things to keep in mind.
Tax pitfalls for crypto investors to be aware of in 2022 and 2023
One of the biggest tax pitfalls for crypto investors and traders is not considering the USD value of their trades and only fixating on the crypto returns. This leads to not being prepared for their tax liability. If someone makes 0.5 ETH profit on a trade, when ETH was $4,000, then the taxable gain is $2,000. ETH can drop in value by 25%, but the taxable event is still based on the USD value at the time of the trade. If investors don’t convert funds into USD and put it aside for taxes, they can find themselves having to sell assets just to cover their tax bill, erasing their profits.
Another tax pitfall for crypto investors is the assumption that the IRS can’t track blockchain transactions. This is not true. But it causes people to not keep good records and to fail to file their taxes. People think that the IRS cannot track crypto transactions, but that is false. First, most people buy crypto at US based centralized exchanges (like Coinbase, Gemini, Robinhood, etc.) and there your social security number and ID are collected (KYC/AML). Even when you move your digital assets out of centralized exchanges and onto the blockchain, the accounting thread remains intact. The blockchain is a public ledger where every transaction is verified in a decentralized manner, making most of the public domain transactions. Because of KYC/AML and open ledgers, the IRS can often link on-chain wallets to their owners. Hundreds of thousands of IRS warning letters are going to be sent out this year. Every tax return requires you to answer Yes or No to a question concerning your purchase, sale or use of virtual currencies.
Investors need to keep good records from Day 1. It is very easy to lose track of all your accounts, wallets and transactions.
The differences between how crypto and stock transactions are taxed
The IRS treats crypto as property, meaning it is taxed very similarly to other capital assets like stocks, bonds and real estate. Gains on crypto transactions are taxed via either a long or short term capital gains rate, dependent on the individual’s income bracket. Some activities such as mining and staking rewards are taxed as ordinary income. Some tokens have been labeled a commodity and not a security.
Another interesting difference between accounting for stocks and crypto is that there is currently no wash sale rule in place for crypto trades. The wash sale rule prevents you from repurchasing the same asset within 30 days of selling and still taking the tax deduction on a capital loss. This rule does not apply to crypto transactions or any other transactions not specifically identified by law which public securities (stocks) are. This lets investors sell for a loss then immediately re-buy to minimize their taxable gains for the year. Recent proposed legislation has sought to close this loophole as most crypto is traded as if it were a tech stock.
Regulatory changes to the crypto space and regulatory changes I would recommend
A crypto sandbox for innovation like Switzerland or Canada is doing. The US should be a place where talented people want to start their companies. It should not be a place where entrenched interests are allowed to shape the market to benefit only the largest companies, forcing startups to flee overseas.
Also, a de minimis exception for crypto transactions should be put in place so we can start testing out crypto in commerce rather than triggering a taxable event every time we buy a cup of coffee. Retail vendors and payments companies are all looking to crypto, making payment processors very worried.
General trends and the future of crypto
Every Fortune 50 tech, finance and fintech company has crypto/blockchain projects. They all wanted to monopolize some portion of the market but seem to have given up on those ambitions and are all just moving as fast as they can now. These companies will spend tens of billions every year in marketing and R&D. Venture capital is going to invest tens of billions a year. M&A activity is going to pick up here now too. Even if corporate valuations are too high now, you are still going to see massive amounts of real economic activity move on — chain to crypto.
Increased institutional and government adoption, especially as inflation increases and the general public has less faith in the current economic system. Brands and large corporations will likely begin to use crypto and/or NFTs to gain customers and align incentives. As the asset class grows even larger, we can only expect further regulation from government agencies.
In addition to the increased institutional adoption, crypto will gain popularity amongst retail/the average citizen as well. NFTs have exploded in popularity and have onboarded many new people into the crypto space over the past year. According to a study out of the University of Chicago, approximately 13% of American adults have interacted with cryptocurrencies in some form. Globally, every notable college and professional athlete is going to earn income via Name Image Likeness rights (NIL).
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.