Tips for Dealing with the Inevitable - Bitcoin and Taxes

Experts say 18-21 million new investors will need to take declaring crypto earnings seriously on their tax returns.

In a letter shortly before his death, in November 1789, Benjamin Franklin, one of the legendary wits of the one-liner, gave us one last aphorism: "...in this world, nothing is certain except death and taxes".

Given the frenzy of enthusiasm in the crypto world, any heartfelt supporters might add "Bitcoin" to Franklin's shortlist of utter certainties. But even if we accept Bitcoin as an inevitability, it sadly does not cancel out the others Franklin mentioned.

Since the beginning of the Bitcoin bull run in December 2020 many new retail investors have invested in Bitcoin.

Social media has been a 24x7 frenzy of enthusiasm as investors celebrated every death-defying leap Bitcoin took on its way to a more than 300% surge over the last 12 months. In February, Bitcoin spiked 16% to an all-time high of $48,200, driven in part by Elon Musk's announcement that Tesla had purchased $1.5 billion in Bitcoin.

So what will these new Bitcoin investors do with all their earnings? Answers vary -- but one thing they will do with any 2020 earnings is to declare them on their tax returns.

With the tax filing deadline just a month away on Thursday, April 15th ready to handle their new crypto gains? Are their small-town CPAs ready for the challenge?

Paying Central Government on Decentralized Earnings

Taxes are another step in the growing pains of mainstream adoption -- and with new changes to the tax forms and details in tax codes, it is something that new retail investors should pay close attention to. The IRS certainly is paying attention to them.

Kell Canty, CEO and co-founder of Verady, a blockchain platform that offers crypto accounting tools, said, "The challenge we see is tax professionals being ready for the onslaught of crypto taxpayers. Tax preparers and accountants will have to get up to speed on both crypto and crypto tax to support their clients."

Canty went on to say it isn't just the accountants who are anticipating a problem. The IRS is aware of the situation and is watching it carefully.

"The IRS has admitted it has a major compliance problem with decentralized investments. Hence the John Doe summons to major exchanges and moving the ‘Virtual Currency' question front and center on the main tax form. We estimate upwards of 18 to 21 million taxpayers will likely need to answer this question on their 2020 returns. Likely more than the service has ever seen."

Justin Woodward, Co-Founder TaxBit, a crypto tax software, concurred and stated, "...the IRS has issued warnings against cryptocurrency investors under-reporting their crypto holdings. With the increase in popularity, there will be increased attention from the IRS on crypto tax reporting. The IRS audits on a two-year lag, we have seen a massive uptick in users who failed to file crypto tax returns in previous years and are now under audit. Cryptocurrency investors must take filing their crypto tax returns seriously.."

Wendy Walker, Solutions Principal of Sovos anticipates two primary pains when it comes to retail investors executing their taxes related to crypto trading.

"First, there is the challenge of establishing cost-basis… Crypto assets can be transferred between platforms seamlessly to take advantage of price discrepancies. This is all fantastic for the retail investor.. but it creates a nightmare scenario when it comes to establishing a cost-basis for trading activity.

Second, there is no uniformity in third-party reporting. At the end of the year, an individual receives a 1099-B from the broker/dealer of choice. This same 1099-B is sent to the IRS which they use to ensure individuals are reporting their income accurately. However in the digital asset space, there is no clear guidance from the IRS as to what is required from crypto exchanges and as a result, individual investors receive a variety of different 1099 forms, all of which report gross proceeds rather than actual gains/losses. As a result, the IRS is left to assume crypto investors are underpaying their taxes and a CP2000 notice is then generated and sent to the taxpayer."

Wendy noted this past September, the Treasury Inspector General for Tax Administration issued a report highlighting this discrepancy and suggested potential solutions.

As tax codes are wont to do, the situation just becomes more complicated the more you explore the issue.

Arianne Flemming COO of Informal Systems, a blockchain R&D institution, pointed out other potential flaws in the system, and stated, "In the US, crypto is treated as a capital asset, and any sale of crypto is subject to capital gains tax. Current IRS guidance requires users to track capital gains and losses on each transaction ie. the difference between the cost basis and the price at the time of sale… transactions that occur peer to peer need to be manually monitored, and it's the individual's responsibility to record the gains or losses properly. Crypto to crypto transactions (ie. buying ETH from BTC) is also a taxable event."

Sometimes doing the right thing isn't as easy as it should be, and that applies to filing taxes. Confusion around tax code exposes retail investors to a greater risk of being audited, according to Brendan Kittredge, Founder of Whispernode.

"Lack of regulation clarity puts investors at risk of incorrect filing and increased risk of audit… It's not that people don't want to pay taxes appropriately, but in some cases, it's almost impossible to do so. If you ask five different CPAs you might get five different answers," Kittredge said.

Crypto Tax Planning

The number of new crypto investors filing taxes in the U.S. is unprecedented, the IRS is pivoting to collect earnings that have often gone unreported in previous years, and the details of the rules around reporting can become complicated with decentralized digital currency. However, there are things retail investors can do to handle taxes most advantageously -- and it means taking a strategy that runs throughout the whole year, not just at tax time.

Scott Melker, popular crypto influencer known as "The Wolf of All Streets", gave this advice to investors filing for 2020 who want to meet their obligations without deteriorating their crypto holdings: "It is essential to understand that every single trade, whether you realize a profit in USD or not, is taxable -- even if you trade between coins. The safest way to remain compliant is to take roughly 30-40% of the profit out into dollars and hold it for tax time. You do not want to be forced to sell Bitcoin at a loss to cover gains that you never realized in dollars."

Ben Weiss, President, COO, and Co-Founder of Coinflip reminded us that it's important to bear in mind both our losses as well as our gains. "Keep in mind that while you must account for capital gains from bitcoin, you can also deduct capital losses. If you have losses on bitcoin or other cryptocurrencies, declare them on your tax return and maybe then you can reduce your tax liability," Weiss said.

Wendy Walker reminded us that there really is no replacement for the value of keeping good records.

"Keep a detailed paper trail of all of your trading activity in the event of an audit. Pick a crypto tax solution designed for retail investors to help in this process. This will make your life infinitely easier. And pay your taxes. No one enjoys doing it but chances are it will save you time, money, and anxiety in the long run," Walker said.

Conclusion

The consensus among respondents was mixed, with some hope for more clarification in the new U.S. administration.

The tax issue should not diminish the enthusiasm of crypto investors who have been winning in record-breaking proportions and will not turn away others from jumping on the Bitcoin train even as it eyes the $50,000 mark.

However, it is important to bear in mind that Bitcoin and other crypto holdings are viewed as property like anything else by the U.S. government. Responsible record keeping and compliance with tax codes should be a part of your investment strategy throughout the year.

Fortune favors the prepared, and in the case of taxes, it particularly favors those who keep good records.

Cover Image by Eric Perlin and Pete Linforth from Pixabay

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