The excitement around cryptocurrencies is everywhere.  Did you profit and sell some of your Crypto positions?  Don’t be that person who thinks that crypto is off the grid and Uncle Sam will not come for you.  If you have gains, you more than likely will owe taxes. How are cryptocurrencies taxed?

Bitcoin

Ethereum

Binance

Dogecoin

Cardano

These are the top five cryptocurrencies according to Market Capitalization on May 10th, 2021.  Over the weekend, Elon Musk hosted Saturday Night Live and much of the leadup was speculation on what he would say about Dogecoin.  In fact, there were thousands of live streams on Twitter with the price of Dogecoin and the SNL episode streaming side-by-side Saturday night.

The mainstream adoption of cryptocurrencies isn’t slowing down anytime soon.  The government may want it to go away, but it isn’t.  As more people are aware and accumulating various digital currencies there are implications that are currently very mysterious.

In this edition of Transformation Tuesday, I discuss Crypto, NFTs, how their gains are taxed, and some challenges for wealth planning with digital assets.

Are Cryptos Really Currencies?

Many people think of currencies like the U.S. Dollar, The Euro, The Yen, and the Lira.  While cryptocurrency has the word “currency” in the name, it’s a little misleading, at least as far as taxation goes. Similar to other investments like stocks, the IRS views cryptos as property.  This distinction is important because it means that cryptos are subject to capital gains taxes.  When preparing your taxes this year, you may notice your CPA asking you if you sold and cryptocurrency this past year.

That is because the yes/no question about whether you have been involved in any digital currency transactions moved all the way up to Page 1 of the 1040.  Previously, it was down under Schedule 1.

This type of question can be used by the IRS to make note of items it may look further into if you answer Yes.  You are now on record stating you have engaged in cryptocurrency positions in a document signed under threat of perjury.

Crypto holdings, at least in the eyes of the IRS are more of a security than a currency, so cryptocurrencies have many of the same tracking and reporting requirements that stocks have. The problem for the government is the very nature of cryptocurrency.  Even though every transaction is captured on the blockchain, many transactions are anonymous. Rarely is an entire crypto position garnered in one transaction.  More likely it has either been mined over time or gathered at different times, in different sizes, at different prices.  Dollar-cost averaging into crypto positions by purchasing every month can cause much stress come tax time.  Every single purchase could create its own taxable event.

Even further than the tax challenges, crypto is hard to integrate into more traditional wealth planning techniques.  As more wealth is created with crypto assets, more sophisticated planning may be beneficial.

Planning Challenges for Digital Assets

With many wealth management strategies, It is common to move assets into a trust to help control the assets and pass them on in a tax-efficient manner.  Trusts typically consist of a grantor (who gifts the money into the trust), a trustee (who is in charge of the trust), and the ultimate beneficiary.

But, access to a crypto wallet is private.  To meet the requirements of a trust, you would need to give access to a trustee, who would then move the assets to a new wallet with a unique key that the initial grantor doesn’t know.  Much of this is currently up to legal interpretation and I would imagine challenges to legal structures are on the way.  The book is just now being written on how to plan efficiently for the management and transfer of crypto assets.

How NFT Taxation is Handled

What about NFTs?  NFTs are nonfungible tokens or digital assets like art and sports cards held digitally.  Currently, the IRS is deeming them to be collectibles by those buying and selling them.  In 2020 and 2021, collectibles are taxed at higher 28% rates than current long-term capital gains rates.  However, the definition of collectibles for tax purposes includes the word tangible.  Like gold, silver, comic books, actual physical sports cards, and actual physical art.

How can something be tangible and digital?  I imagine further argument and ultimately, clarification are on the horizon.  These are questions that will have significant implications in wealth planning.

All of this is at the Federal Level.  What about at the state level?  States often lag behind and piggyback on federal laws.  The majority of states don’t even differentiate between capital gains rates and income rates.  Everything is treated as “income”. I think the next few years will be very pivotal in determining how digital assets will ultimately be taxed and transferred.

Summary

• Crypto assets are taxed at capital gains rates determined by the length of your holding period.  Less than 12 months are short-term capital gains determined by your marginal income tax bracket.  Long-term capital gains held over 12 months are generally taxed at lower rates.  
• NFTs are deemed to be collectibles currently, so all gains attributable to them will be taxed at the 28% collectible tax.

Proper tax planning involves looking at various scenarios and how they affect your wealth, BEFORE making a decision. Everyone’s financial situation is different.  You should consult any tax-related moves with your tax advisor.

Cheers!

Colin Exelby, CFP®

This is general tax information and hasn’t considered your personal tax situation. It is based upon current tax information available in April, 2021. This information should not be relied upon as tax advice.  Please consult your tax professional.  This information is for educational purposes only.   The solutions discussed may not be suitable for your personal situation, even if it is similar to the hypothetical example presented. Investors need to make their own decisions based on their specific investment objectives, financial circumstances, and tolerance for risk.

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