Consultants – many of whom still struggle to anticipate the very existence of cryptocurrencies – are increasingly faced with the terrible prospect of figuring out how to plan with and for them.
As the price of Bitcoin continues to rise and non-fungible tokens suddenly hit the mass media’s attention through fantastic stories like Beeple’s recent sale at Christie’s for an incredible $ 69 million in ether – the first time the venerable auction house has accepted payments via crypto – Digital currencies and assets are quickly entering the mainstream and your customers’ lives.
However, as with many things in technology, our reach is often beyond our reach, and by and large, crypto owners do not fully understand many of the financial implications of using them, often simply assuming that they function similarly to fiat currencies. That’s not the case.
One area where advisors can fill this knowledge gap is in the rapidly evolving area of digital asset taxation.
Although cryptocurrency has the word “currency” in its name, it is misleading. “As with other investments like stocks, the IRS views cryptos as property,” said Joel Reville, CEO of Two Ocean Trust Company in Wyoming. This distinction is important as cryptos are subject to capital gains taxes.
Crypto holding is more of a security than fiat currency for tax purposes and involves many of the same tracking and reporting requirements. This is where it gets difficult.
Ron Gong, managing partner of Catalyst Family Office, an offshoot of MyCFO, says the confusion over taxing cryptocurrencies “could lead to billions in unintentional non-compliance by taxpayers”.
The nightmare of Crypto’s cost base
Every transaction with crypto generates at least one and probably several taxable events on both sides.
Beeple himself isn’t just hooked for taxes on the NFT he sells – NFT creators who sell their original work report the selling price as decent income, even if they receive cryptocurrency as payment (crypto used to pay for goods and / or services) reported by the recipient as normal income) – but the buyer is similarly liable for capital gains taxes on the difference between what he originally paid for the ether and the valuation of $ 69 million at the time when he used it to “pay” for art.
This is just the simplest version of the scenario as we assume the buyer has collected all of the Ether they used in a single transaction with the same initial cost base. Far more likely, the ether was collected over the course of thousands of transactions, each of which has the potential to generate its own taxable event and need to be individually reported and tracked to determine its future foundation, let alone whether it is should be taxed as short or long term profit.
When you start to consider that some of these transactions may have been for fiat currencies while others were exchanging crypto themselves, the rabbit hole gets very deep. And all just to find out the tax owed on a large purchase.
These reporting problems are of great consternation to both experts and the IRS. Even being fully aware of the way crypto is taxed, there is still a tremendous amount of information to keep track of. For customers who are completely unaware and assume that they can use their cryptocurrency as a currency as well, the potential for omission errors penetrates the area of security.
The IRS is aware of the potential for error here, but will not tacitly pass on the potential billions in revenue due as a result of these transactions.
One key indicator is that they recently moved the yes / no question of whether a taxpayer was involved in digital currency transactions to page 1 of Form 1040. It was previously buried in the tax forms under Appendix 1 where it was easy to overlook.
Gong said the IRS frequently uses such check box questions for items it wishes to investigate further, as the taxpayer is notified of the existence of their holdings or transactions in a document signed under threat of perjury. This provides the service with an easy starting point for further investigation into the details, should they deem it important.
Even if the presence of crypto transactions is ascertained, there is some debate about how feasible it is to actually sort out the details.
This is where one of the great crypto paradoxes comes into play. Every transaction is recorded and recorded in the blockchain – that’s the attraction. However, crypto transactions are often carried out anonymously. While all information needs to be checked, it can be difficult to see who is behind the transaction. Experts disagree on whether it will be easier or more difficult for government agencies to track crypto transactions as opposed to fiat transactions. That they have a vested interest in trying is certain.
Wealth Planning Challenge – Who Is In Control?
Aside from the reporting challenges, cryptos don’t play a good role with a number of wealth planning techniques. “There is almost an inherent conflict between this new asset class and traditional methods of wealth planning for generations,” says Revell. “To take advantage of many traditional planning techniques, the owner of the property must give up control of the property. However, cryptocurrency is inherently self-sovereign. The two concepts are simply not congruent. “
Access to a crypto wallet is determined by the combination of a public and a private key. Anyone who knows the private key can access the wallet. As long as you know the private key, it is practically impossible to give up control of the assets it contains. For example, to meet the requirements of a trust, access would have to be granted to a trustee who would then move the assets to a new wallet with a unique key that the original grantor did not know – a simplified version of the way Revell’s own trust Company handling the trust bypasses challenge.
However, the tax implications of digital wallets themselves are still murky. Much is left to the legal interpretation and has so far remained unchallenged. Experts say it won’t last.
Is an NFT Really a Collectible and Other Tax Issues?
Another interesting feature highlighted by Beeple’s NFT sale is how cryptos interact with legal definitions that are never meant to cover digital assets.
Whether or not an NFT is truly a “collector’s item” is important as this changes the rate at which it is taxed. NFTs are certainly considered collectible items by those who make and buy them. However, the definition of collectibles for tax purposes conspicuously contains the word “material”. Can something be both digital and tangible? Currently, some NFTs are being treated as collectibles and some are not. But where was the line drawn between the two? These are questions that have not yet been answered by the IRS but have significant financial implications.
After all, the state tax laws when treating cryptos are far more diverse and (in most countries) unclear. In fact, the majority of states don’t even distinguish between capital gains and normal tax rates, which could seriously increase the potential risk of certain customers if they simply followed the federal model.
The one question that advisors and clients seem to be concerned with the most: “How easy is it to turn crypto back into real money?” actually has the simplest answer.
Both Revill and Gong agreed that in the theoretical case that a customer sold an item for $ 69 million in crypto and had to cash an eight-digit amount of it in order to pay the tax bill, it would only take a few days .
However, both also stressed that they would advise against it as the associated transaction fees would make it extremely inefficient. However, this schedule is not very different from what would be required to convert a similar amount of securities into cash. That speaks for the growing liquidity of the market – just a few years ago, crypto holders came across brick walls and tried to convert coins worth USD 10,000 back into fiat currency.
Despite the challenges, the emergence of crypto and digital assets in the mainstream is not slowing. Much remains unknown. Customers – and the IRS – will have questions. Consultants who are committed to giving them the best advice need to familiarize themselves with the answers.