IRS Commissioner Charles Rettig, testifying before Congress in April 2021, estimated the gap between taxes owed and taxes collected in the United States at nearly $1 trillion. Although there is some debate about the contribution of lax cryptocurrency transaction reporting to this so-called “tax gap,” with market capitalization hovering at the time of writing around $2 trillion, Cryptocurrency investments are increasingly coming under regulatory scrutiny.
Disclosure of Virtual Currency on Form 1040
Since Notice 2014-21, the IRS has always considered cryptocurrencies to be property for US federal income tax purposes. Absent any specific legal or regulatory exception, individual U.S. taxpayers are generally required to report gains made on the sale of goods (including cryptocurrency) and pay taxes on those gains. To remind taxpayers of this requirement, Form 1040 now specifically asks taxpayers whether they have received, sold, traded, or otherwise disposed of a financial interest in a virtual currency. (The instructions define “virtual currency” for this purpose as a digital representation of value other than a representation of “real” (i.e. fiat) currency that functions as a unit of account, a store of value or a medium of exchange. Cryptocurrencies are included in this definition). The question on Form 1040 requires an affirmative answer of “yes” or “no” from all taxpayers.
A version of the question about virtual currency was included in Schedule 1 of Form 1040 when it was introduced in 2019 but, starting with the 2020 tax year, the question took a more prominent place on the page. 1 (and, at that time, asked, “At any time in 2020, have you received, sold, sent, traded, or otherwise acquired a financial interest in any virtual currency?”). The wording of the question has been changed for the 2021 tax year to remove the word “send” and replace “acquire otherwise” with “dispose otherwise”, consistent with the IRS’ emphasis on identification of taxable events involving cryptocurrency. Generally, any transaction involving cryptocurrency during the tax year will require a taxpayer to answer “yes” to this question, with the exception of purchases of virtual currency with real currency (with no other activity ).
Extending 1099-B and 8300 reports to digital assets
During his congressional testimony, Rettig also recommended that Congress pass legislation requiring disclosure of information for cryptocurrency transactions. The Infrastructure Investment and Jobs Act (IIJA), signed into law by President Biden on November 15, 2021, does just that.
Under the new law, “any person who (for compensation) is engaged to regularly perform any service effecting transfers of digital assets on behalf of another person” is a “broker” for the purposes of Section 6045. of the tax code and is required to declare these transfers. to the IRS on Form 1099-B. The IIJA defines “digital assets” as “any digital representation of value that is recorded on a distributed ledger secured by encryption or similar technology specified by the Secretary”, unless otherwise specified by the Secretary (a broad definition that may encompass a range of crypto-assets, including, perhaps, “non-fungible tokens” or NFTs). Failure to comply with this reporting requirement would result in penalties under Section 6724 of the Internal Tax Code.
This definition of “broker”, as amended by the IIJA, has been criticized by some members of Congress and many in the cryptocurrency industry as being too broad, as the language could potentially attract other participants in the cryptocurrency ecosystem such as miners and wallet developers, rather than just cryptocurrency exchanges. A bipartisan group of lawmakers attempted to revise the wording to address these concerns, but the proposed amendment did not make it into the final bill. While it remains to be seen how the US Treasury, which will be responsible for implementing the new reporting requirement, will interpret the language, unofficial statements from the Treasury indicate that it will not seek to enforce this requirement against minors and hardware developments.
The IIJA is also amending Section 6050I, which generally requires taxpayers who receive more than $10,000 in cash in the course of their business or commercial activity to report that receipt to the IRS on Form 8300, to apply digital asset receipts. The new reporting requirements apply to returns that must be filed and returns that must be provided after December 31, 2023.
The new reporting requirements are expected to generate $28 billion in additional revenue over the next ten years, according to estimates prepared by the Joint Committee on Taxation – a considerable sum, but unlikely to have a significant impact on the tax gap.
Other legislative proposals
Other potential legislative changes affecting the taxation of cryptocurrency transactions are currently under consideration by Congress. The “Build Back Better Act” (BBBA), which was approved by the United States House of Representatives only to block the United States Senate, would extend the “sham sale” rules of Code Section 1091 and the sale rule Constructive of Section 1259 of the Code to Cryptocurrency Assets. A wash sale is a strategy that effectively provides an investor with a tax-deductible loss while maintaining their position in an investment. Section 1091(a) of the Code prohibits an immediate deduction of losses where a taxpayer sells at a loss and repurchases the same or something “substantially similar” within thirty days before or after the sale at a loss, but is limited by its conditions to the sale at a loss of shares, securities and certain options. Since cryptocurrencies are not considered “securities” for the purposes of these rules under current law, crypto investors have been able to gain a tax advantage by “reaping” tax losses during market declines. without actually cashing in the investment.
The implied sale rules in Code Section 1259 seek to remedy the opposite situation: a taxpayer effectively liquidates an appreciated financial position without recognizing a taxable gain. Under current law, the disposal of an appreciated financial position in a stock, debt obligation or interest in a partnership in a short sale or a forward or forward contract for the same property or a substantially similar property is treated as an implied sale and therefore as a taxable event. The BBBA would limit the use of wash selling and constructive selling strategies by cryptocurrency investors by extending the application of Sections 1091 and 1259 of the Code to digital assets such as cryptocurrency.
It remains to be seen whether Congress will reconsider these proposals in 2022, either as part of the BBBA or as a standalone bill. However, the proposed changes suggest a growing congressional interest in closing what some perceive as “tax loopholes” when it comes to this asset class. (The changes to the wash and implied sell rules discussed above were estimated at $16.8 billion over 10 years, according to the Joint Committee on Taxation.) We’ll update our coverage of these proposals at as discussions in Congress continue.