Compounding a rough year for Bitcoin and other cryptocurrency: IRS proposes new confusing question about digital assets

Investors may need all the help they can get from the tax code’s capital loss rules

Cryptocurrency investors have been enduring a year where their holdings have plunged in value when some hoped the asset could be a hedge against red-hot inflation.

The Internal Revenue Service could have a potential head-scratcher of a question about your crypto investments and what’s taxable, according to a major accountants’ association.

For two years, the IRS has been asking whether taxpayers have bought or sold cryptocurrency in the main “Form 1040” document that taxpayers submit for their federal income taxes. The inquiry asks about other potential crypto-related tax events too. It’s a “yes” or “no” question that taxpayers can’t leave blank.

Last year, the Form 1040’s asked: “Did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” (The wording differed slightly from the language appearing on the Form 1040 the year before that. The question first appeared in tax year 2019, on the Schedule 1.)

The prominent placement is a nod to the IRS’ increasingly sharp focus to ensure cryptocurrency investors completely meet their tax obligations.

Fast forward to next year’s tax returns: The IRS has proposed a draft question asking for next year’s Form 1040: “At any time during 2022, did you: (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”

However, after the IRS unveiled that question’s proposed wording ahead of 2023’s tax season, the American Institute of CPAs recommended the tax agency get out its pencils and erasers. The tax agency needs to clarify the question to avoid taxpayer confusion, the organization said in its comment letter.

As a general matter, capital gains taxes will kick in on sales, exchanged coins, obtaining cryptocurrency through mining and other scenarios. But buying cryptocurrency and then just holding it has not counted as a taxable event. When jobs pay with cryptocurrency, for instance, they are typically treated as wages subject to employment tax, the IRS says.

In some ways, the newest version of the question is an improvement, said Annette Nellen, a tax professor at San Jose State University who chairs the AICPA’s virtual currency task force. But including the phrase “’digital asset’ is going to create new problems and new confusion,” she said.

Apart from cryptocurrency such as Bitcoin BTCUSD, -2.27% or Ethereum ETHE, -3.59% ETHUSD, -2.52%, using a phrase like “digital asset” raised questions if the IRS was also asking about nonfungible tokens (NFTs) and gaming currency like Fortnite’s V-Bucks or the Robux offered on Roblox RBLX, -5.98%, AICPA noted.

The IRS has previously removed V-Bucks and Robux from examples of virtual currency that can convert to real-world money. But creating, buying and selling NFTs can have tax implications.

So what’s the solution? The best approach would be a question asking if taxpayers during the year had “a taxable event involving virtual currency” and then point to instructions on what that means, AICPA said in its comment letter.

Those instructions, it added, should specify that an individual filer does not have to check “yes” if their child or dependent had their own cryptocurrency-related tax events generating income below the filing thresholds.

The back and forth on tax document wording may sound like dry semantics, but it underscores how much is still being figured out about cryptocurrency, taxes — and the public’s continuing need to understand the ways the two interact.

The AICPA’s comment letter wants the IRS to stick for now with the term “virtual currency” instead of “digital asset.” But even still, it notes, there are variations in how the IRS formally and informally defines “virtual currency” in its guidance and instructions.

One reason investors need to understand the tax rules now is because it might help take some sting out of their 2022 losses. Investors can use capital losses to offset their gains. If loses exceed gains — and that might be the unfortunate case for some hard-hit cryptocurrency investors — a taxpayer can claim up to $3,000 in capital loses. Any remaining loses can be carried forward to future tax years.

Bitcoin BTCUSD, -2.27% was trading just over $20,000 on Thursday, down nearly 57% from the start of the year. Ethereum ETHUSD, -2.52% is down more than 57% year to date.

Nearly two in ten U.S. adults said they owned cryptocurrency as of August, according to an ongoing Morning Consult poll. The 18% in August is roughly even with the start of the year.

Matt Metras of MDM Financial Services in Rochester, N.Y., has a rosier view on the question the IRS is trying to pose. “It’s not perfect, but it’s better than it was last year,” said Metras, who specializes in tax preparation for cryptocurrency holders. “The use of digital assets is more inclusive,” he said.

Still, Metras doesn’t know if there’s ever going to be a crystal-clear, concise and perfectly phrased way the IRS can quiz about cryptocurrency holdings. The landscape keeps changing so fast, he noted.

The agency is thinking about “readability and the information to be collected,” when it puts new language on a tax form, said Michael Kramarz, director of Kaufman Rossin’s tax services advisory group.

“A taxpayer’s response to an information request on a tax form is only as good as the question being asked. If a taxpayer cannot understand the language on a tax form, the IRS will not be able to collect the type and breadth of information it seeks,” said Kramarz, a former IRS attorney.

The IRS will consider comment from tax professionals and the general public as it comes up with tax-document wording, Kramarz noted. They can submit comments here.

Typically, finalized tax forms start rolling out around November and December, Nellen said. The IRS declined to comment.

In Metras’ view, “There’s a lot of confusion out there in the general public about what’s reportable and what isn’t,” with cryptocurrency. As a result, “there are people out there dabbling in it who are unsure of the question.”

Now owners of crytpocurrency and tax professionals will have to wait on the IRS’s final wording. “How it ends up is always a fun surprise,” Metras said.

Read the full article at Market Watch.