The Internal Revenue Service (“IRS”) categorizes cryptocurrency as virtual currency and views these assets as property, with any transactions resulting in the potential for ordinary income or capital gain. Even if virtual currencies are exchanged for goods and services, as opposed to being sold outright, the IRS views this as a bartering activity and would expect the holder to pay taxes on the appreciation of the assets at the time of the transaction. However, the IRS doesn’t allow a taxpayer to recognize a tax loss if the cryptocurrency transaction was personal in nature.
As we close the books on 2020, cryptocurrency holders should be developing end of year strategies on how to make the most of their cryptocurrency transactions and related taxes. Below are a few considerations if you held or transacted with cryptocurrency during 2020.
The CARES Act, which was passed by Congress during the first few months of the COVID-19 pandemic, has many provisions that benefit individual taxpayers. Two of the most notable provisions affect charitable contributions. For 2020, a taxpayer who doesn’t itemize their deductions (and takes the standard deduction of $12,400 for single filers or $24,800 for married couples filing joint tax returns) is allowed a maximum $300 deduction for any charitable contributions made throughout the year. Prior to the CARES Act, if a taxpayer did not itemize, they could not receive a tax benefit from their charitable giving.
In addition, the CARES Act allows a 100% of adjusted gross income (AGI) deduction for charitable donations made directly to a qualified charitable organization. The Pre-CARES Act maximum percentage was 60% of AGI. Therefore, if a taxpayer has an AGI of $100,000 for 2020, they can essentially donate $100,000 and reduce their taxable income (previously, they would be limited to a $60,000 reduction). It is important to note that this change is only for 2020 as the 60% limitation is expected to return for the 2021 tax year.
Given both of those changes above, a taxpayer can donate cryptocurrency to a qualified 501(c)(3) charity and potentially lower their 2020 tax bill. However, it is worth noting that because cryptocurrency is treated as property by the IRS, the rules on donating property would also apply. Therefore, the taxpayer would need to complete Form 8283 if the value of their cryptocurrency is more than $500. If the value is greater than $5,000, a qualified appraisal is usually required to be obtained and attached to the tax return in order to substantiate the amount that is claimed as a deduction. As it relates to virtual currency, a qualified appraisal is highly recommended if the fair market value of the donated cryptocurrency is not readily available.
Any gains recognized from the sale of cryptocurrency, if held as an investment or capital asset, is subject to capital gains tax rates. Unlike earned, or ordinary income, the tax rates on capital gain income is significantly less. For tax year 2020, ordinary income can be subject to a tax rate as high as 37%. The highest capital gains tax rate is 23.8%, which is a 20% capital gain rate + a 3.8% rate for net investment income tax.
If we look at the other end of the spectrum, it is possible for a cryptocurrency holder to pay 0% capital gains tax on the sale of their virtual currency during 2020. If a single taxpayer has $40,000 or less in total taxable income, or a married filer with $80,000 or less, the capital gains rate is 0%. As an example, if a married filer has $70,000 of taxable income in 2020, any capital gain income is not subject to income tax.
It is important to note that the length of time the cryptocurrency has been owned, or holding period, factors into the capital gains rate as well. The favorable capital gains rates mentioned above applies to long-term capital gain. A long-term holding period is defined as greater than one year. If the virtual currency was held for less than one year and eventually sold, the holding period is considered short-term in nature and the gain would be taxed at the seller’s ordinary income tax rate.
In 2017, Congress passed the Tax Cuts and Jobs Act (“TCJA”). It came with many changes to the U.S. tax code, one of which surrounded Qualified Opportunity Zones (“QOZ”). At its core, the QOZ program is meant to boost development in economically distressed communities. This is made possible by Qualified Opportunity Funds (“QOF”), which come with tax incentive for potential investors.
Taxpayers who recognize capital gain income in 2020 through 2026 from sale of virtual currency (or any other capital asset such as publicly traded stock) can defer the tax impact by investing the gain into a QOF. The cryptocurrency holder would have 180 days from the date of the sale to invest the funds. The deferred gain would become taxable either on December 31, 2026 or when the investment in the QOF is sold, whichever event is earlier.
There are additional rules that can reduce the percentage of the gain that will eventually be taxable, which include how long the taxpayer holds their investment in the QOF. It is also worth noting that many of the rules surrounding QOZs and QOFs could be modified or repealed under the new Presidential administration. More guidance on this topic can be found on the Withum Resource Page for Qualified Opportunity Zones.
The standard tax advice is to defer income and accelerate deductions. However, as uncertain as 2020 has been overall, the same can be said for tax rates in upcoming years. The TCJA referenced earlier had decreased tax rates starting with the 2018 tax year. It also created a new taxable income bracket for capital gains tax rates. With a new administration in place starting January 2021, it is unclear as to what changes may be approved regarding future tax rates.
The IRS has made a strong effort in recent years to hone in on those that hold cryptocurrency. They have issued several notices and guidance regarding virtual currency, including an FAQ Page dedicated to the taxation of such transactions. The importance of recordkeeping cannot be emphasized enough, as many cryptocurrency platforms struggle with providing taxpayers with the necessary information to accurately complete their tax return. The tracking of items such as tax basis, wash sale considerations, and non-taxable transactions often falls on the cryptocurrency holder, so accurate and up-to-date records are paramount to ensure tax returns are not under or over reporting virtual currency activity.
Additionally, starting in tax year 2020 the IRS has included a specific question directly on page 1 of Form 1040 asking taxpayers if they’ve received, sold, or exchanged virtual currency during the year. This question appeared for the first time in 2019, but on a supporting schedule, further highlighting the IRS’ ongoing efforts in tracking holders of cryptocurrency and eventually collecting tax on related transactions. Proper planning is necessary in mitigating taxes and maximizing wealth when transacting in the virtual currency space.