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Can Tax Planning Software Help Your Clients in a Bitcoin Crash?

The concept of cryptocurrency has been around since the 1980s, but specific currencies and the blockchain technology that tracks them only made their way into mainstream media about a decade ago. Public interest has waxed and waned since then, but at the beginning of 2021, we saw interest (and coin prices) soar once again. But coin prices are extraordinarily sensitive to changes in the market and public perceptions. Just this month, new restrictions from the Chinese government, new revelations about how bitcoin mining affects the climate, and Elon Musk’s tweets have moved coin prices all across the board, making cryptocurrency investment anything but stable. Early investors in cryptocurrencies have certainly made a killing, though. Bitcoin, for instance, was selling at $1 a decade ago but sold for $56,000 on May 1, 2021. Many people who invested in Bitcoin and other popular currencies are looking at large investment gains. When virtual currencies first became available, the IRS had little to say about them, but today it’s clear what activity is taxable. Learning how the IRS views cryptocurrency is important so you can adjust your clients’ tax plans for their activity. If you have a good quality tax planning software, you can build those assumptions into their plan to help them prepare for and manage their tax liabilities.

Let’s look at two examples:

Example 1: Cryptocurrency as an Investment

On January 1, 2020, Taxpayer purchased 15 Ether at $127 each, totaling $1,905. On March 1, 2021, they sold all 15 Ether for $1,493 each, totaling $22,395. On their 2021 tax return, they should report a long-term capital gain of $20,490.

Assuming their capital gains are taxed at 20%, they will have an additional income tax liability of $4,098.

Example 2: Cryptocurrency as a Currency

On January 1, 2020, Taxpayer purchased 30,000 Dogecoin at .2 cents each. On March 15, 2021, they used 10,000 Dogecoin to pay for a ticket to a Dallas Mavericks NBA game, who now accept some cryptocurrencies as payment methods. On that date, Dogecoin was trading at 5.86 cents. On their 2021 tax return, they should report a long-term capital gain of $566.

Assuming they are subject to a 20% capital gains tax rate, they will have an additional income tax liability of $113 for using Dogecoin to pay for a Maverick’s ticket.

How Do You Calculate Tax Basis?

When calculating your clients’ gains and losses from cryptocurrency sales, you’ll need to know which assets they’re selling so that you know which basis to use in your calculations. Should you identify assets using a first in, first out (FIFO) method? Last in, first out (LIFO)? What about highest-in, first out (HIFO)?

The IRS gives us some guidance in their Frequently Asked Questions (FAQ) document. This document states that, for tax purposes, taxpayers can select which assets they sold. This allows you, as their tax advisor, to optimize their gains/losses based on their cost basis in each asset.  To identify assets, your client must have records that show:

  1. The date and time they purchased the asset.
  2. The amount they purchased it for and the fair market value on that date.
  3. The date and time they sold the asset.
  4. The selling price of the asset.

Most of this information is tied to the asset’s private key, but if information like basis is not known – like if your client received an asset as a gift or through nontraditional means like a hard fork, an airdrop, or mining – or if your client simply opts not to specifically identify the assets included, you must default to a FIFO method for determining which assets have been sold.

What Else Should I Know?

Not all cryptocurrency activity is as straightforward as the examples we shared. Fortunately, the IRS provides clear information that can help ensure you’re reporting your client’s activity correctly. Here are a few things you might want to know.

Will my clients have a capital gain or loss if they move their currency between wallets?

No. Moving virtual currency between wallets is not a taxable event. It’s important that you talk to your client about their virtual currency activity because exchange platforms may flag a wallet-to-wallet transfer as a disposal (and therefore send the client an information return). You will need to judge for yourself whether that transaction is taxable.

Are hard forks and soft forks taxable?

Hard forks and soft forks can be taxed differently.

Hard forks occur when your client’s cryptocurrency changes protocol, resulting in a permanent diversion from the original distributed ledger (i.e. a new currency is created). Revenue Ruling 2019-24 discusses the tax consequences of hard forks. In general, hard forks are nontaxable events. Owners of the original assets will not recognize income from the assets held in the new ledger because they have no ownership over those assets. 

However, if your hard fork is followed by an airdrop, you will need to recognize income. An airdrop occurs when units of the new cryptocurrency are transferred to the owners of the original currency. Airdrops may follow hard forks but don’t always. When an airdrop occurs, the taxpayer will record the fair market value of the recently-acquired new currency as ordinary income on their tax return. Soft forks are different; soft forks happen when a distributed ledger undergoes a protocol change, but no new ledger is created. Soft forks have no tax effects.

Will gifts of virtual currency affect gift taxes?

Yes. If your client gifts cryptocurrency, the gift tax rules would apply as if they gifted any other capital asset. The fair market value can be determined using the trading value of that asset as of the date of the gift. The recipient will not need to report the gift as income.

Where will cryptocurrency transactions be reported on my client’s tax return?

Sales of virtual currency should be reported on Form 8949, Sales and Other Dispositions of Capital Assets. You will also need to check a box on the front page of Form 1040 that indicates your client sold or exchanged cryptocurrency. This is a new question on the 2020 version of the form.

Incorporate Your Client’s Cryptocurrency into Tax Planning

Now that tax compliance season is over, it’s a good time to shift into tax planning. Like other capital assets, your clients’ cryptocurrency investments can be great tools to use when building a tax plan. If you work closely with your clients, you can help them time their virtual currency sales in the year that makes sense from a tax planning perspective. For example, if your clients are holding onto losses and looking to get rid of their investments, you can help them determine the optimal time to recognize those losses. Where a client has both gain and loss positions and seeks to cash out part of their holdings, you can also use asset identification to reduce the tax impact of generating needed cash. Corvee’s tax planning software can show you (and your clients) what their 2021 and 2022 tax positions will look like so that your clients can select the best year to initiate the sale. Our software also generates an easy-to-read deliverable that helps you sell your tax planning services to your clients. They’ll be able to see in dollars how much your tax strategies will save them. If you’d like to see a demo of these deliverables and see how our tax planning software works, reach out to us today.

Start Tax Planning Today with Corvee.

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