Financial advisors who disdain digital assets might think they're far removed from cryptocurrencies, which have been rocked by the bankruptcy filings of the FTX exchange and BlockFi, a digital asset lender. In fact, all advisors are at least ankle-deep in the asset class, and they have the Internal Revenue Service to thank for that position: For the second straight year, the nation's tax collector asks all American taxpayers a pointed question about their cryptocurrency holdings, right at the tippy top of their federal returns.
On filings submitted this year, the query was "At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?" Come the filing season next April,
Taxpayers sign their returns under penalty of perjury, so coming clean is essential to avoiding penalties, interest and worse — as well as an opportunity for advisors to get to know some clients better.
"The most important thing for advisors with crypto is that question on the 1040," said Lacey Shrum, a lawyer at Vela Wood in Dallas whose clients include registered investment advisory firms working with strategies for blockchain, the technology behind digital assets. "Clients are either saying 'yes' or 'no', and advisors at least need to know that piece."
Read more:
If bitcoin, ethereum and other digital currencies are on the IRS' radar screen, they're also occupying client mindshare. While crypto holdings for most individuals are relatively small — the median flow is less than one week's worth of take-home pay — almost
Read more:
Understanding the notoriously volatile asset class is hard — bitcoin peaked at around $68,000 in November 2021 and
The paper chase
Investors are required to report their crypto transactions to the IRS, which treats cryptocurrency as property, not as money, and taxes it like a stock. Taxpayers must disclose gains and losses, with profits on assets held for more than a year taxed at the long-term capital gains rate, now a top 23.8%, which includes the Affordable Care Act levy. The exceptions: When crypto is received as payment for goods or services, used to pay someone else or swapped for another currency, it's taxed as ordinary income at ordinary rates, now a top 37%.
Investors with brokerage accounts holding stocks, bonds and funds go through this reporting ritual pretty much seamlessly every year. But figuring out profits and losses on crypto hinges on knowing what you originally paid, or your cost basis. For digital assets that have moved between exchanges and wallets or been airdropped as free currency into your wallet, that determination can be a nightmare. It's even more tangled if foreign or decentralized exchanges, which avoid platforms and route trades directly between investors, or if "forks," when the computer code underlying a coin splits into two, are involved.
When exchanges provide confusing documents, or none at all, things get tricky fast. "Sometimes just even figuring out what is taxable to you can be very difficult," said Erin Finnimore, the head of tax and information reporting solutions at TaxBit, a tax and accounting firm in Draper, Utah, for digital assets. Companies like hers, CoinLedger and CoinTracking sell services that let investors import complex transaction data from their exchanges, but some investors are wary of the disclosure needed.
Brokerages like Schwab and Fidelity send customers a form each year that documents what they need to report to the IRS. But not all crypto exchanges do so; those that provide details do so through various incarnations of a broad form known as a 1099. The IRS gets a copy of each form sent.
Read more:
Some exchanges send a 1099-B, similar to a brokerage statement for stock trades that details cost basis, gross proceeds and capital gains and losses.
"I don't think that 1099s are their priority right now," Shrum said.
Starting next year, exchanges and payment networks such as Venmo must issue the forms if customers have at least $600 in cash or crypto transactions. The prior threshold was $20,000 across at least 200 transactions. While the 2021 law that created the requirement generally treats exchanges as brokerages, it's unclear about who exactly is a broker and thus must provide the documents. Software developers, crypto wallet "suppliers" of storage services for digital assets and miners who verify and create new tokens
Some investors might receive a 1099-K, which shows the volume of all transactions with a given exchange, regardless of whether they're taxable, but no details on gains and losses.
"Unless you're using a large-scale exchange or custodian, you're on your own," said Shrum.
Washed out
Cryptocurrency may be taxed like stocks, but it's not subject to one big stricture that governs shares. The
That means some investors can sell their losing crypto, buy it back immediately when it rebounds, and use the loss to offset profits on other investments. The strategy is basically tax-loss harvesting — a staple with exchange-traded funds — that's not subject to the wash-sale rule.
Read more:
If the losses exceed the profits cashed in on other investments, an investor can use what's left to reduce up to $3,000 of ordinary income a year and roll remaining amounts forward to lower taxes in the future. With short-term capital gains, on assets held for less than a year, equal to ordinary rates, an affluent investor in a high-tax state like California can
Read more:
