The Nuances of Virtual Currency Tax

2022 was a challenging year for the cryptocurrency (aka crypto) industry, caused by the collapse of the cryptocurrency exchange FTX (the third-largest crypto exchange at the time). The result has been a shift in the cryptocurrency industry, with newly minted crypto millionaires facing sudden losses. Many have had to sell their cryptocurrencies at a lower cost than they paid, getting out of the industry now rather than incurring further losses.

An easily overlooked aspect of this series of events is the effect on taxes. Is there even a virtual currency tax to be worried about? What is the process for recording losses when it comes to digital currency? How does this affect Certified Public Accounts (CPAs)? Read on to learn all about the ins and outs of virtual currency tax.

Learn more: Cryptocurrency and Accounting: What Do You Need to Know?

Why are cryptocurrencies attractive to investors?

Did you know cryptocurrencies are not subject to Internal Revenue Service (IRS) taxes? Well, that’s true as long as cryptocurrencies are:

  • Held in a portfolio
  • Not earning interest from scenarios such as staking

This fact makes cryptocurrencies attractive as an investment. With cryptocurrency, investors realize gains or losses whenever they trade in crypto, which includes using it to buy products or exchange coins for other types. So, if an investor buys a product with a cryptocurrency worth far less when it was purchased, the IRS will tax the difference in the crypto price as a long-term capital gain or loss. This is one of the benefits of cryptocurrencies.

If a cryptocurrency is sold at a higher value than it was initially bought, investors will need to report any capital gains to the IRS. However, if they held the asset longer than a year (making it a long-term asset) and are selling it at a loss, they can offset those losses against other income on their tax return.

Also read: CPAs: What You Need to Know for the 2024 Tax Season

Selling at a loss

Is selling at a loss a negative outcome? In many cases, yes, but compared to stocks or assets, the extra benefit of cryptocurrencies is that selling at a loss is potentially beneficial. That’s because the IRS considers virtual currencies as property, which matters because a property is not subject to wash sale rules (which state that investors cannot sell their assets at a loss and immediately repurchase the same asset).

Since virtual currencies are property and do not have to obey wash sale rules, cryptocurrency holders can sell their coins at a loss, realize that loss on their taxes, and immediately repurchase the currency. One important note to remember is that this only works if there is value in the coin. Investors can sell the coin and report the losses on their tax returns if any value is left. However, if the coin’s value is zero, the IRS declares the currency worthless and is now treated as a miscellaneous itemized deduction on a tax return.

How should losses be recorded?

If investors plan to sell their cryptocurrency, filling in the correct forms during the tax season is essential to record these sales. Virtual currency tax is decided by Form 8949, specifically for sales and other dispositions of capital assets.

However, there are a few more steps along the way:

  • First, determine whether the transactions were short-term (the asset is held for less than a year) or long-term ( the asset is held for longer than a year). The long-term capital gains tax rate is better than the short-term.
  • Next, group transactions based on whether they were reported on a 1099-B. Since crypto exchanges do not issue 1099-Bs, mark the option on the 8949 form that indicates this.
  • Now, Form 8949 can be filled out. Investors and CPAs should follow the guidance from the IRS here, which will have answers to any confusion along the way. This step is where losses or gains from cryptocurrencies are recorded.
  • Ultimately, your losses or gains flow into your 1040 income tax return.

How are the losses calculated?

Calculating crypto losses and gains should be as simple as figuring out the difference between purchase and sale price, but the reality is that crypto exchanges do not have to keep track of this information. When investing in cryptocurrencies, the purchaser might be responsible for tracking the sale price.

The IRS also allows you to use those losses to offset other taxable investment profits on your tax return. These losses are referred to as “realized losses” and can be used to offset gains that you have realized in other investments.

In the case of cryptocurrency, gains or losses are realized whenever you dispose of it, which includes situations such as exchanging one cryptocurrency for another or using it to make purchases. For instance, if you bought a cryptocurrency like Bitcoin for $30,000 a few years ago, and then used it to purchase a $60,000 car, the IRS would consider the $30,000 increase in value as a “realized gain” and tax it as a long-term capital gain, in addition to any state or local sales taxes.

While crypto tax programs allow CPAs to input the purchase date and the number of coins purchased to calculate the gains or losses, the best solution is for investors to keep track of sale prices as they deal in crypto.

How can virtual currency tax be as risk-free as possible?

CPA firms seeking to outsource their accounting services should understand the risks regarding virtual currency tax. This need has only become more pressing, considering the current cryptocurrency climate. Given the industry’s volatile nature, mistakes happen, and a firm’s reputation is at stake when sending client information to third parties.

McGowan PRO provides Accountants Professional Liability/Errors & Omissions Insurance to protect CPAs. CPAs can rest easy knowing they can access specialized risk management and protection from professional liability claims. McGowan PRO also offers broad coverage options and education in risk management strategy, giving CPAs additional confidence in their coverage.

Contact an expert from McGowan PRO today.