Digital assets are a growing part of total assets for many individuals and households. But as more types of digital assets emerge, they can make filing your taxes much more difficult. While tax laws concerning digital assets will continue to evolve in the coming years, you must understand current tax laws to plan for tax filing in a way that minimizes your tax liability.
What are Digital Assets?
Digital assets are not real currency (fiat currency) because they are not paper and coin money backed by a government’s central bank. They do have value, though. Many are used for payment for goods and services, digitally traded by users, and exchanged for or into real currencies or digital assets. Digital assets are treated as property by the Internal Revenue Service. Generally speaking, digital assets fall into three categories:
- Virtual currency/cryptocurrency: Cryptocurrency is the most common type of digital asset and includes currencies like Bitcoin, Dogecoin, and Ethereum. These currencies can be exchanged for physical currency; therefore, they are considered convertible virtual currency by the IRS. Any cryptocurrency with an equivalent value in U.S. dollars would fall into this category.
- Stablecoins: Stablecoins are a subset of cryptocurrency that attaches its value to a real-world commodity, such as gold. This strategy can minimize some of the volatility found with most cryptocurrencies. As such, they can be used for many payments or financial transactions, and the IRS treats them like all other cryptocurrencies.
- Non-fungible tokens: Non-fungible tokens, or NFTs, are not a form of virtual currency. Rather, they are digital assets backed by blockchain. A physical comparison would be valuable collectibles. NFTs often include pieces of art, gaming assets, or domain NFTs.
Before the rise in popularity of NFTs, the IRS often referred to all of these assets as virtual currency, but the term digital assets is much more inclusive, and the IRS adopted this term in the 2022 tax year.
How to Report Digital Assets and Understanding Tax Requirements
Transactions involving digital assets must be reported to the IRS. Forms 1040 and 1040-SR include a box to indicate whether the filer has received digital assets as payment, award, or reward for property or services or disposed of any digital assets through a sale, exchange, or transfer.
Digital transactions that must be reported include:
- A sale of digital assets, including NFTs, cryptocurrency, or stablecoins.
- An exchange of digital assets for property, goods, or services.
- The receipt of digital assets as payment for goods or services.
- The receipt or transfer of digital assets for free that does not qualify as a bona fide gift.
- The receipt or transfer of digital assets as a result of mining or stalking activities.
- The receipt of new digital assets from a hard fork.
- An exchange or trade of digital assets for other digital assets.
- Any other disposition of a financial interest in digital assets.
If you engage in any of these activities, you must report all income related to the digital asset transactions. Generally speaking, this is reported using Form 8949 Sales and Other Dispositions of Capital Assets. This form helps taxpayers determine their capital gain or loss and report it on Schedule D Capital Gains and Losses on Form 1040.
If the taxpayer received digital assets as compensation or disposed of any digital assets, they must report that income as a similar type. For instance, it would be listed as W-2 wages on Form1 1040 and 1040-SR to report it as compensation. If it can be classified as inventory or services, it would be included on Schedule C. Finally, if the digital asset transaction was a gift, the taxpayer must use Form 709 United States Gift (and Generation-Skipping Transfer) Tax Return.
The bottom line is that digital assets are treated like other assets when reporting for tax purposes. And while this sounds straightforward, it can quickly become confusing. Unfortunately, if you fail to report your digital currencies, you will likely receive a notice from the IRS that as unreported income, you may need to pay penalties and interest. If you sold unreported digital assets in previous years, the IRS can go back up to three years and penalize you for a failure to report.
Cryptocurrency and digital assets are much harder to regulate and tax properly. However, the International Organization of Securities Commissions has proposed rules for global cryptocurrency regulation. Individuals with digital assets may want to consult with an accountant to determine the best path for accurate reporting of digital assets. For more information related to tax planning for digital assets, contact Parker Business Consulting today.
Parker Business Consulting & Accounting, P.C. is a unique firm with more than a combined 75 years of experience in private industry, coupled with a strong background in public accounting. This combination enables us to provide valuable assistance based on direct experience with many of our clients’ same issues.