Crypto creates new hurdles for financial advisors this tax season

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Cryptocurrency investors face two big headaches this tax filing season: the Internal Revenue Service is ramping up scrutiny of digital assets, and some investors owe large tax bills after cashing in last year’s hefty profits on Bitcoin and other blockchain-based coins.

The twin challenges, a counterpoint to Bitcoin’s blockbuster gains so far this year, create new complexity for financial advisors with clients in digital assets. Investors can also owe tax if they received crypto as payment for work, or if they used Bitcoin to shop at retailers like overstock.com or Home Depot.

Most advisors direct their clients who want to invest in digital currencies to special exchanges, like Coinbase, or to niche funds. But while advisors usually rely on their clients to do the heavy lifting come tax time, they’re not entirely off the hook.

“This is going to be the first season where we tackle” clients’ crypto taxes, “and on a case-by-case basis,” says Chad Norfolk, a CFP and Senior Financial Advisor at WMS Partners in Towson, Maryland. The firm, he says, helps clients “aggregate the data and get it over to the accountant.” But for some clients, “we might have to triage it with the accountant.”

Navigating a tangle of electronic records
Merely owning crypto is not a taxable event; potential tax bills arise only if an investor sells, trades or spends it. That's where things get woolly for tax purposes.

Digital-asset exchanges don’t typically send investors an annual statement showing the gains or losses needed to calculate a tax bill, in contrast to what traditional brokerages and funds do for stocks and bonds. Some crypto firms and funds send out a 1099-K statement, with a copy to the IRS, but that only shows gross proceeds. And the forms go only to investors who have undertaken more than 200 transactions with at least $20,000 in gross proceeds.

Some firms don’t even send out that statement. Exchange Coinbase, the most valuable crypto company in the U.S., ditched the statements this year in favor of a separate 1099 form for investors who racked up at least $600 last year in various fees and rewards.

The upshot is that many investors have to sift through their electronic records to manually calculate their cost basis: what they paid for their crypto, what they sold or traded it for, and the resulting tax owed on the difference. Bitcoin, now at around $49,000 after years in the doldrums (it spiked briefly in December 2017 before falling back), nearly tripled last year, finishing close to $29,000.

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Even the pros find the taxes daunting. “It’s complicated,” admits billionaire investor Michael Novogratz, the founder, chief executive officer and chairman of Galaxy Digital Holdings Ltd., a financial firm focused on digital assets and blockchain, with $1.2 billion in its asset management unit. Novogratz keeps his personal crypto holdings at Galaxy, which uses KPMG and Canadian accounting firm Davidson & Co. for tax preparation.

The IRS’s big question this year
The IRS treats Bitcoin, Ethereum and other digital currencies not as money but as property, taxing it like stocks or real estate. Investors owe capital gains rates — for short-term assets held less than a year, that’s the ordinary individual rate, now topping out at 37%; for long term held at least a year, a top 20%.

Crypto investors aren’t great at reporting to the IRS what they own. And the IRS knows it. For the first time, the agency this year asks all individual taxpayers high up on their federal returns to disclose whether they sold, received, sent, exchanged or “otherwise acquired” any financial interest in any virtual currency.

It’s a yes-or-no question, and taxpayers tick or leave blank the appropriate box under penalty of perjury when they sign and file their returns. Preparers handling returns for filers who make a mistake on that question or lie can face monetary penalties if they or the filer is caught.

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The fess-up question was buried in the last tax season’s 1040. This year, it’s smack dab on top of the first page, right below the lines for a filer’s name, address, social security number and filing status.

Taxpayers who simply own crypto, or transferred some last year between their digital “wallets” — software that stores an investor’s crypto — can tick “no.” But answering the question gets tough when a taxpayer owns Bitcoin through a partnership, according to Shehan Chandrasekera, a CPA and the Head of Tax Strategy at CoinTracker, a software company for crypto taxes. Is it the taxpayer that owns the asset, and thus has to disclose it? Or is it the partnership, which files its own return — one that doesn’t include the yes-or-no question?

The crypto tax calculus gets even more complicated when accounting for air drops, in which coins appear out of nowhere in your digital wallet. And for forks, when a currency unexpectedly splits in two. The IRS generally considers both taxable, but it’s still refining guidance for other issues.

“The advice to clients is, if you’re going to be dabbling or trading, you need to track these things, keep accurate records, spreadsheets,” says Douglas Boneparth, a CFP and President of Bone Fide Wealth, an advisory firm in New York that caters to millennials. “Even if an accountant is going to help, the onus is on the client to produce that data set.”

Coming after crypto holders
The IRS doesn’t have a lot of information about crypto owners. Online venues that let people trade with each other directly, known as decentralized exchanges, as well as foreign exchanges and digital wallets almost never report an investor’s activity to the IRS. “If you jumped on the bandwagon and started buying and selling things, there are plenty of people who have no idea come tax time what to do,” Boneparth says.

Lewis Taub, the Director of Tax Services at accounting firm Berkowitz, Pollack & Brant in Miami, Florida, sees a parallel with the agency’s crackdown on holders of undisclosed Swiss and Swiss-style bank accounts, a dragnet that since 2009 has snared more than 56,000 American taxpayers and brought in over $11.1 billion. “The IRS is looking for these transactions like they looked for foreign bank accounts several years ago,” he says.

Boneparth, who is a “brand ambassador” for digital currencies for the AICPA, the leading professional association for accountants, argues that if investors keep their records straight, “they don’t need to go to a special accountant. At the end of the day, an asset was bought or sold at a given price, and accountants are used to dealing with that.” But Adam Blumberg, a CFP and a co-founder of Interaxis, an educational firm for fintech, blockchain and digital assets, disagrees. “There are so few CPAs that actually understand what they’re doing with crypto. “

Recordkeeping pain
Crypto tax software firms can ease the record-keeping pain. But only a fraction of investors appear to use them. Cointracker says it has 100,000 users. ZenLedger has more than 10,000 customers. That’s a tiny slice of the estimated 36.5 million Americans who owned crypto in 2019, according to a survey by finder.com, a personal finance app.

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The real problem with manually tracking things comes when an investor moves digital assets between accounts and then sells, according to ZenLedger’s founder and chief executive officer, Pat Larsen. “The cost basis is lost,” he says. So any statements from an individual provider “won’t know about your previous transactions. You may have numbers that are wildly off” for tax purposes.

All this makes for an often-bewildering layer of involvement for financial advisors.

“With crypto, it’s really a self-directed account by the client,” says Norfolk. “They provide the statements to the accountant. If the accountant wants a second pair of eyes, we come in.”