Curtailing Cryptocurrency Tax Surprises
As investing in Bitcoin, Dogecoin and other cryptocurrencies becomes increasingly popular, investors need to understand the potential tax ramifications. Unlike traditional currency, the IRS views cryptocurrency as property for federal income tax purposes and even asks about it on Form 1040.
Many transactions involving cryptocurrency — such as purchases of goods or services — become taxable events where the purchase is also considered a sale. In addition, certain changes to the blockchain (the distributed digital “ledger” on which cryptocurrency transactions are typically recorded) can trigger taxable income.
Gains and losses
Because cryptocurrency is property, investors recognize a capital gain or loss when they sell it in exchange for traditional currency. As with other capital assets, the amount of gain or loss is the difference between the adjusted basis in the cryptocurrency (usually, the amount paid to acquire it) and the amount for which it’s sold. And, as with other capital assets, gain or loss may be short term or long term, depending on whether an investor held the cryptocurrency for more than one year. If cryptocurrency is sold at a loss, there may be limitations on the deductibility of the capital losses.
Cryptocurrency owners often are surprised to discover that using cryptocurrency to pay for goods or services can also trigger a capital gain or loss. Let’s say you purchased 10 units of cryptocurrency 10 years ago for $1,000 each, or a total of $10,000. This year, when the cryptocurrency’s price has climbed to $5,000 per unit, you use it to purchase a $50,000 car. Assuming your adjusted basis in the cryptocurrency is $10,000, you’ll recognize a $40,000 long-term capital gain. Generally, your gain or loss is the difference between your adjusted basis in the cryptocurrency and the fair market value of the goods or services you receive in exchange for it.
Forks and drops
In some cases, a cryptocurrency owner may recognize taxable income because of certain blockchain events. Taxable income may be triggered even if you don’t conduct transactions or take any other actions with the cryptocurrency.
IRS guidance in 2019 addressed the tax implications of two types of blockchain events: “hard forks” and “airdrops.” A hard fork occurs “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.” Put much more simply, it’s when a single cryptocurrency is split in two.
A hard fork may or may not be followed by an airdrop, which the IRS describes as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” According to the guidance, when an airdrop follows a hard fork, it “results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency.” In simpler terms, it’s when “free coins” representing the new cryptocurrency are dropped into the existing cryptocurrency wallets of the owners of the legacy cryptocurrency.
If the new cryptocurrency isn’t airdropped or otherwise transferred to an account of the legacy cryptocurrency’s owner, a hard fork doesn’t trigger taxable income. On the other hand, if a hard fork is followed by an airdrop (which enables owners to immediately dispose of the new cryptocurrency), the owner recognizes ordinary income in the year the new cryptocurrency is received.
Buying and selling cryptocurrency involves significant risk, including the possibility you could lose part or all of the money you’ve invested. Tax treatment of cryptocurrency is also subject to change. The IRS will likely continue to provide guidance on the distinctive tax issues presented by cryptocurrency. We can help you stay current on these developments and work with you to avoid unpleasant tax surprises.
A Tax Quirk of Being a Business Partner
If you’re a partner in a business, you may have encountered a situation that gave you pause: In any given year, you may have been taxed on more partnership income than was distributed to you. The cause of this quirk of taxation lies in the way partnerships and partners are taxed.
Unlike regular corporations, partnerships aren’t subject to income tax. Instead, each partner is taxed on the partnership’s earnings — whether or not they’re distributed to the partners. Similarly, if a partnership has a loss, the loss is passed through to the partners. (Be aware that various rules may prevent partners from currently using their share of a partnership’s loss to offset other income.)
While a partnership isn’t subject to income tax, it’s treated as a separate entity for purposes of determining its income, gains, losses, deductions and credits. This makes it possible to pass through to partners their share of these items.
A partnership must file an information return, which is IRS Form 1065, “U.S. Return of Partnership Income.” On this form, the partnership separately identifies income, deductions, credits and other items. This is so partners can properly treat items that are subject to limits or other rules that could affect their treatment at the partner level.
Examples of such items include capital gains and losses, interest expense on investment debts, and charitable contributions. Each partner gets a Schedule K-1 showing his or her share of partnership items.
Basis and distribution rules
Basis and distribution rules ensure that partners aren’t taxed twice. A partner’s initial basis in his or her partnership interest (which varies depending on how the interest was acquired) is increased by his or her share of partnership taxable income.
When that income is paid out to partners in cash, they aren’t taxed on the cash if they have sufficient basis. Instead, partners reduce their basis by the distribution amount. If a cash distribution exceeds a partner’s basis, then the excess is taxed to the partner as a gain (often, capital gain).
The tax ins and outs
Partnership structure offers owners many benefits, but it’s important to understand the tax ins and outs. Contact us to discuss further.