Article

Taxation of Cryptocurrency and Other Digital Assets

February 13, 2024

Which digital asset transactions must be reported?

Generally, all digital asset transactions must be reported to the IRS.

If a particular asset has the characteristics of a digital asset, it will be treated as a digital asset for federal income tax purposes. Digital assets are treated as property for federal tax purposes. General tax principles applicable to property transactions apply to digital asset transactions.

What form is used to report digital asset transactions?

Taxpayers filing Form 1040, 1040-SR, 1040-NR, 1041, 1065, 1120, 1120 or 1120S must answer the digital asset question on that form. Each form essentially asks:

“At any time during 2023, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”

The question must be answered “Yes” or “No” by all taxpayers, not just by those who were involved in a digital asset transaction in 2023.

Typically, taxpayers check “Yes” if they:

Received digital assets as payment for property or services provided;
Received digital assets resulting from a reward or award;
Received new digital assets resulting from mining, staking and similar activities;
Received digital assets resulting from a hard fork (a branching of a cryptocurrency’s blockchain that splits a single cryptocurrency into two);
Disposed of digital assets in exchange for property or services;
Disposed of a digital asset in exchange or trade for another digital asset;
Sold a digital asset; or
Otherwise disposed of any other financial interest in a digital asset.

How to report digital asset transactions on Form 1040?

All income involving digital assets must be reported on a federal tax return.

Examples of how to report digital assets include:

If a taxpayer disposed of any digital asset, which was held as a capital asset, through a sale, trade, exchange, payment, or other transfer, the taxpayer must complete Form 8949 to calculate their capital gain or loss and report that gain or loss on Schedule D (Form 1040).
If a taxpayer received any digital asset as compensation for services or disposed of any digital asset that was held for sale to customers in a trade or business, the taxpayer must report the income as any taxpayer would report other income of the same type (for example, W-2 wages on Form 1040 or 1040-SR, or inventory or services on Schedule C).
If a taxpayer disposed of any digital asset by gift, they may be required to file Form 709.

What legislative changes have been made to digital asset transaction reporting?

In 2021, the Infrastructure Investment and Jobs Act (Infrastructure Act) clarified and expanded the rules for information reporting on sales or exchanges of digital assets by brokers under §6045 and §6045A, and for reporting business transactions involving receipt of digital assets in excess of $10,000 under §6050I. The IRS announced that these Infrastructure Act reporting requirements do not apply until the IRS issues final regulations under §6045, §6045A, and §6050I.

Until the IRS issues new final regulations for those changes by the Infrastructure Act:

A broker must continue to report gross proceeds and basis as required under existing §6045 and regulations, which do not specifically address the extent to which such requirements apply to sales or exchanges of digital assets and do not specifically include digital assets as a specified security subject to basis reporting.
A broker must furnish statements on transfers of covered securities as required under existing §6045A and regulations, which do not specifically address the extent to which such requirements apply to transfers of digital assets.
Businesses must continue to report cash received in excess $10,000 in the course of business, as required under existing §6050I and regulations, which do not address the receipt of digital assets.

What are the proposed regulations for digital asset transaction reporting?

The IRS created the proposed regulations in support of the changes made by the Infrastructure Act to help resolve uncertainties involving the taxation of digital asset transactions and to prevent taxpayers from using digital assets to hide income. The proposed rules are a part of the IRS’s larger campaign to increase tax compliance, especially for wealthy taxpayers and large corporations, as well as to close the tax gap of about $688 billion, of which studies suggest that at least $50 billion is due to unreported cryptocurrency transactions.

On August 25, 2023, the IRS issued proposed regulations on information reporting by brokers for sales or exchanges of digital assets. Key highlights of the proposed regulations include:

The definition of a broker would include digital asset trading platforms, digital asset payment processors, certain digital asset hosted wallet providers, and persons who regularly offer to redeem digital assets that were created or issued by that person.
Real estate reporting persons, who are treated as brokers for reportable real estate transactions, would be required to include the fair market value of digital asset consideration received by real estate sellers in reportable real estate transactions on filed information returns and furnished payee statements.
Real estate reporting persons would be required to file information returns and furnish payee statements with respect to real estate purchasers who use digital assets to acquire real estate in these transactions.
The proposed regulations would provide specific rules for determining the amount realized in a sale, exchange, or other disposition of digital assets and for calculating the basis of digital assets.

When would the proposed regulations become effective?

Important effective dates for the proposed regulations regarding digital asset transactions include:

The proposed regulations would require brokers to report gross proceeds on a newly developed Form 1099-DA and to provide payee statements to customers for sales or exchanges of digital assets that take place on or after January 1, 2025.

The proposed regulations would require real estate reporting persons, who are treated as brokers for dispositions of digital assets, to report the disposition of digital assets paid as consideration by real estate purchasers to acquire real estate in real estate transactions that close on or after January 1, 2025. These real estate reporting persons would also be required to include on Form 1099-S the fair market value of digital assets paid to sellers of real estate in real estate transactions that close on or after January 1, 2025.

The proposed regulations would require brokers, in certain circumstances, to include gain or loss and basis information for sales that take place on or after January 1, 2026, on their information returns and statements, so that customers have the information they need to prepare their tax returns. In such case, brokers would be required to report the basis of certain digital assets acquired on or after January 1, 2023, which were disposed of on or after January 1, 2026.

Note that although the proposed regulations do not require such information reporting until 2026, certain proposed rules require brokers and taxpayers to keep track of the basis in any digital assets acquired on or after January 1, 2023.

Cryptocurrency rewards received from staking is included in gross income

The IRS ruled that a cash-method taxpayer who staked cryptocurrency native to a proof-of-stake blockchain and received additional units of cryptocurrency as rewards when validation occurred must include in gross income the fair market value of the validation rewards in the tax year the taxpayer gained dominion and control over such rewards.

Charitable deduction for donated cryptocurrency

The IRS denied a taxpayer’s charitable deduction for donated cryptocurrency because the taxpayer failed to meet the qualified appraisal requirement and the reasonable cause exception.

Generally, for a §170 charitable donation deduction of more than $5,000, a “qualified appraisal” must be obtained unless the reasonable cause exception applies. The IRS ruled that the taxpayer’s use of the value reported by a cryptocurrency exchange on which the donated cryptocurrency is traded meets neither the qualified appraisal requirement nor the reasonable cause exception.

Loss deduction for worthless or abandoned cryptocurrency

The IRS denied a taxpayer’s loss deduction claiming that its cryptocurrency was either worthless or abandoned because it had substantially declined in value.

Section 165 provides a deduction for losses that are evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the taxable year. The IRS ruled that the cryptocurrency was not worthless because it was still being traded on a cryptocurrency exchange and the taxpayer made no affirmative act to abandon the cryptocurrency.

State taxation vs. federal taxation

At the state level, crypto taxation brings with it another important consideration: sales tax. Most states, though, have no guidance or legislation on the sales tax, as of yet. Of the few states that do, some, such as California and Kentucky, treat crypto as equivalent to cash in transactions, and tax it according to the same standard. In other states, such as Arkansas and Washington, digital currencies aren’t subject to taxes.

[Explore a Practitioner Perspective Special Report on recent international developments of cryptocurrency’s classification and taxation.]

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