The IRS really wants to know about your cryptocurrency. For the 2020 tax year, the IRS moved the cryptocurrency question from Schedule 1 of Form 1040, where it was in 2019, to the much larger position on page 1 of Form 1040. himself. The question is the second piece of information requested, just after the name and address of the taxpayer. The question reads: “At any time in 2020, have you received, sold, sent, traded or otherwise acquired a financial interest in a virtual currency?” The draft instructions for Form 1040 stated that if you were buying cryptocurrency, you should answer yes to the question. However, the final Form 1040 instructions removed examples that indicated that taxpayers who bought cryptocurrency should answer yes to the question. The question itself has remained unchanged.
On March 2, 2021, the IRS issued new guidance (updating question 5 of its Frequently Asked Questions or FAQs) that read: “If your only transactions involving virtual currency in 2020 were purchases of virtual currency with real currency, you don’t have to answer yes to the question on Form 1040. ”The FAQs are not considered authoritative when taking a position on a tax return and the FAQs change frequently. Relying on FAQs for rock-solid advice is risky. At a minimum, tax practitioners recommend the best practice of printing a dated copy of the relevant FAQs in the client’s tax file. If you do your own taxes, keep a hard or electronic copy with your other tax documents (W2, etc.).
The updated guidelines cause consternation among taxpayers and tax practitioners because they have changed from the original guidelines and because they are confusing. People (including many tax professionals) wonder why taxpayers are allowed to answer no to the question when, if they have purchased cryptocurrency with real currency during the year, they have clearly received or acquired a financial interest in the cryptocurrency during the year.
The confusion arises from the combination of a wordy and somewhat ambiguous question combined with changes to the guidelines. I don’t think many taxpayers pay attention to draft instructions, but tax professionals do. Therefore, the disappearance of the “answer yes if you bought cryptocurrency” examples in the 1040 instructions combined with the recently updated FAQ creates confusion that sometimes seems on the verge of panic. In general, tax professionals are cautious and prefer straightforward answers. This is the kind of situation that makes their eyes tremble.
Still, it’s important to consider both the current authority on cryptocurrency transactions, which admittedly equates to “little”, and what the IRS is trying to accomplish with this matter. They try to determine if the taxpayer has made any taxable transactions related to the cryptocurrency. Buying and holding is not a taxable transaction.
According to the guidelines provided by IRS Notice 2014-21, cryptocurrency is not treated as currency in the eyes of the IRS. It is treated as an asset and is, for the most part, treated the same as stock transactions. Understanding this and the important concept of how earning wealth can create taxable income can help clear up the confusion. The IRS looks for cryptocurrency sales that may generate capital gains and losses. They are also looking for a cryptocurrency receipt which is payment for services, gifts, airdrops, etc.
Payment for services—When taxpayers receive cryptocurrency as payment for the provision of services, it will often be considered self-employment income (unless it is leisure income, which is well over the framework of this article). Self-employment income is typically reported on an individual’s 1040 using Schedule C and often results in self-employment tax (taxpayer’s social security and Medicare taxes) in addition to income tax .
Gifts-Gifts of cryptocurrency (or just about anything else) are not taxable to the recipient. According to Duberstein v. Commissioner, gifts are only gifts if they are offered out of “detached and selfless generosity” and “affection, respect, admiration, charity or similar impulses”. Gifts may require the donor to complete an income tax return and possibly pay tax on the gifts. The IRS will also be looking for gifts that are truly disguised taxable compensation or payment for other property or assets.
Airdrops –Parachutes are perhaps best compared to the legal concept of treasure. Airdrops are, in fact, found money. And the money found (that duffel bag of dollars you found on the side of a desert highway) is reportable and taxable as income. The same goes for airdrops. Drops of cryptocurrency that simply appear in your account or wallet are taxable events. If you receive an airdrop answering yes to the cryptocurrency question, it’s a no-brainer.
Generally speaking, cryptocurrency transactions are reported the same way as stocks.–using Form 8949 and Schedule D with a Form 1040. Short-term gains are taxed as ordinary income. Long-term gains benefit from the most favorable tax rates. The IRS doesn’t expect taxpayers to report every stock purchase they make at the time they do if they don’t sell or have them. They do, however, expect taxpayers to track their purchases (date, base or purchase price and number of units) so that when stocks are sold, the appropriate holding period (short or long term) ) and the gain or loss on the sale can be accurately determined.
It is this writer’s opinion that the IRS says taxpayers can answer no to the cryptocurrency question on the Form 1040 if they have only used real currency to purchase an amount. cryptocurrency data, as cryptocurrency transactions are, for the most part, treated as stock market transactions. That’s not to say the IRS isn’t interested in people who simply hold cryptocurrency. They have made it clear that they are very interested, but they have other ways of getting this information and, at least for the bigger holders, they use it. So while you may answer no to the question, should you answer no? The answer to this question depends on your trading habits and risk tolerance and should be discussed with a trusted tax professional. And if you hold a large amount of cryptocurrency and / or have a high volume of transactions, it is best to find a specialist tax specialist.