Tax Reporting for Digital Assets
Digital assets (or DA for short) are becoming increasingly viewed as not just novelties, but as legitimate investment vehicles and currencies of trade.
When most people think of digital assets, they think cryptocurrency, such as Bitcoin or Ethereum. But the term digital asset has greater breadth of meaning than that. The IRS definition of a DA is to me as good as any. It basically defines them as digital representations of value that are recorded on a cryptographically secured, distributed ledger, and they include virtual currency, stablecoins, and nonfungible tokens.
Because DAs are carriers of value and can be bought and sold for potential gain, the IRS has taken a keen interest in transactions involving them and the resulting tax reporting consequences. The IRS has made it very clear that it considers DAs property, the disposal or exchange of which is a reportable transaction for tax purposes.
Because of this, starting a few years back, the IRS started including a question at the top of individual tax returns asking if the taxpayer had engaged in certain transactions involving virtual currency, such as selling it. Note the use of the word "currency" in the question, meaning it seemed to only apply to that particular type of DA.
Realizing the evolving nature of digital assets, the IRS in 2022 changed the question to update its terminology. The question at the top of every 1040 now reads "At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?"
The nuances of the change are actually pretty significant. Further, the IRS clarified in a recent announcement that ALL taxpayers must answer the question, even if they engaged in NO activity involving DAs. Further, if the answer is YES, the taxpayer must report all income related to the DA transaction. The character of the income and where it is reported on the return will depend on the nature of the transaction.
For instance, if you are someone who held a DA as an investment and sold, exchanged or otherwise transferred it (other than by gift), you would report the transaction normally as a capital gain or loss on "Schedule D, Capital Gains and Losses". As with other capital assets, it would be reported as Short-term if the DA was held one year or less, or as Long-term if held more than one year. If the DA was gifted to someone, you need to report the transaction as a gift on "Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return".
Another interesting example is someone who is paid for their work or services with DAs. An employee would report the value of DAs received as wages, whereas an independent contractor would show theirs as income on "Schedule C, Profit and Loss From Business", just as if they had received cash for their work.
According to the IRS, you must check "Yes" to the new question if you:
- Received digital assets as payment for property or services provided;
- Transferred digital assets for free (without receiving any consideration) as a bona fide gift;
- Received digital assets resulting from a reward or award;
- Received new digital assets resulting from mining, staking, and similar activities;
- Received digital assets resulting from a hard fork (a branching of a cryptocurrency's blockchain that splits a single cryptocurrency into two);
- Disposed of digital assets in exchange for property or services;
- Disposed of a digital asset in exchange or trade for another digital asset;
- Sold a digital asset; or
- Otherwise disposed of any other financial interest in a digital asset.
You don't have to answer in the affirmative just because you owned DAs during the year. You can also check "No" if your DA activities were limited to:
- Holding digital assets in a wallet or account;
- Transferring digital assets from one wallet or account they own or control to another wallet or account they own or control; or
- Purchasing digital assets using U.S. or other real currency, including through electronic platforms such as PayPal and Venmo.
Still confused? The IRS has a Digital Assets page on IRS.gov that may help. But regardless, be sure to answer the question!