It’s been quite the year for the crypto space. 2022 started off strong, with over $2.3 trillion under assets trumpeted with mega-hype, including Super Bowl ads and celebrity endorsements. However, as the year comes to a close, investors find themselves in quite a different landscape as bankruptcies unfold and coin prices plummet. How has the regulatory and investing environment changed, and what are the necessary tax considerations?
Changes in U.S. Tax Guidance
The Internal Revenue Service made a number of adjustments to filing requirements for digital currencies, including more direct questions about crypto holdings, with the most obvious change clearly noted on draft Form 1040 for 2022. Updated from 2021, taxpayers will now answer additional questions regarding their “digital assets” holdings, including whether they sent or received crypto assets as income or gifts. While taxpayers need to check whether or not they were gifted, a gift is taxable only if it goes over the USD16,000 annual threshold or the lifetime threshold, which is currently $12.06 million.
Crypto Exchanges Reporting Taxable Activity
One of the provisions of the 2021 Infrastructure Investment and Jobs Act was a requirement for crypto brokers to report customers’ sale proceeds to the IRS on a 1099 form for assets held in taxable accounts. By beginning to treat crypto assets more like traditional financial assets, investors will no longer be able to avoid tax rules for their crypto holdings.
Bitcoin began the year at over $46,000 per coin and has since come crashing down, dropping as low as $15,000 at one point in November. In fact, recent analysis shows that over 50% of bitcoin addresses are currently worth less than their original purchase price. Investors may be wondering if it is time to close positions if they have not already. This may provide a bit of a bright spot, as these capital losses, if held in taxable accounts, can be used to offset other capital gains — and these gains can be in any other asset class, including equities or real estate.
Proof of Work to Proof of Stake
Ethereum’s Merge resulted in the coin transferring from proof of work to proof of stake — resulting in many investors receiving staking income. And tax implications differ depending on your jurisdiction.
While there is not yet clear guidance on the Ethereum event in the U.S., the IRS has previously defined and used the term airdrop in official tax guidance related to a cryptocurrency hard fork event similar to the Merge. In 2017, the IRS treated the Bitcoin hard fork as taxable income upon receipt of the coins, and capital gains were imposed when the coins were sold.
Taxes due to the Merge will depend on an investor’s jurisdiction. According to guidance in the United Kingdom, it can be inferred that no income tax is applied upon receipt of an airdrop. HM Revenue and Customs – the UK’s tax governing authority, has stated that the Merge upgrade was not a taxable event subject to capital gains. Instead, the cost basis of the existing ethereum token will be attributed to the forked version of Ethereum, and any subsequent disposals will accrue a gain or loss as normal.
The Potential of Gas Fees to Offset Crypto Gains
Put simply, gas fees are blockchain transaction fees generated when users sell or trade their cryptocoins and are typically paid to crypto miners, or network validators,for their services to the blockchain. Gas fees vary depending on the amount of volume in the network — the higher the volume, the higher the fees. While the majority of coins have gas fees, those on the Ethereum network are notoriously high, largely due to the Ethereum network’s many use cases, including decentralized applications, while the Bitcoin network is used for payments.
Gas fees can be added to a transaction’s cost basis or business expenses but cannot be used to offset personal income.
Yield farming is another relatively new concept that involves an investor lending or staking their cryptocurrency, typically through a platform using smart contracts. The crypto is lent out on the blockchain, and the investor receives interest and other rewards. While yield farming provides liquidity to decentralized financial applications, it is considered extremely risky to investors. While the IRS has yet to provide clear guidance on DeFi protocols and yield farming, any cryptocurrency earned through yield farming is considered to be regular taxable income.
At present, the creation of NFTs is not taxable, but if sold, the gains are considered gross income, taxable at the fair market value of the cash or crypto received and may be reduced by costs related to the creation and sale (such as gas fees) of the NFT.
With the bankruptcy of crypto exchange FTX, customers were left with their assets frozen. The outcome of the firm is unclear. Investors may still recover some of their funds — or they may not. If FTX is shut down, and the assets are deemed not recoverable, then the assets will be declared worthless and declared a capital loss, based on the value of securities when they were purchased. Until that clarity is provided, however, taxpayers will need to wait.
The Cross-Border Standardization of Crypto Tax Rules
Crypto tax changes and regulatory updates are not limited to the United States. Authorities across the globe are also discussing how to best move forward.
OECD’s New Framework
In an effort to increase transparency and decrease tax evasion among cooperating countries,
the Crypto-Asset Reporting Framework (CARF) looks to standardize the reporting of tax information for crypto asset transactions. In scope are both individuals, entities and controlling persons.
The European Union
Regulation for markets in crypto-assets, or MiCA, aims to establish harmonized rules for crypto assets, requiring EU-based cryptocurrency companies to register and maintain minimum governance norms. The DAC-7 Directive, which goes into effect on January 1, 2023, introduces comprehensive documentation and reporting requirements for online platforms and marketplaces in the European Union. And the DAC-8 directive looks to ensure uniform disclosures as well as adequate taxation due to investments in crypto assets.
Sources indicate that another proposal is in the works, requiring crypto providers to report details of transactions for EU clients to national tax authorities within the bloc. While details are scarce, reports indicate that the new law will cover cryptocurrencies, stablecoins, non-fungible tokens and derivatives.
A recent provision calls for a 26% tax on crypto trading profits over 2,000 euros. In addition, a draft law by the newly elected government gives taxpayers an option to declare their digital asset holdings, resulting in a tax of 14% on the value of the assets held at the beginning of the year.
Crypto Tax Free Zones
It should be noted that several countries, including the Cayman Islands, Bermuda, Singapore and Switzerland are among the countries that currently have no capital gains or income tax on cryptocurrency holdings. This also applies to the U.S. Territory of Puerto Rico.
Cryptocurrency is Still an Emerging Tax Category
The crypto tax landscape is still nascent, with many complexities and guidance relating to digital and tokenized assets that will be a priority for authorities in 2023. Careful consideration and the advice of a tax consultant who is well-versed in the evolving landscape of cross-border digital asset tax rules is advised in order to properly meet tax obligations and avoid costly future audits.