It’s been a rough year for crypto and crypto investors. The seemingly endless crypto winter, numerous exchange collapses and the ongoing FTX debacle have pushed prices down and triggered ballooning losses. Yet, investors still need to think about their cryptos when filing their taxes.
The Internal Revenue Service says virtual currency is treated as property for federal tax purposes. “General tax principles applicable to property transactions apply to transactions using virtual currency,” according to the IRS.
In turn, this means that capital gains and losses need to be reported and generally will have a consequence on your taxes. Taxes are due when you sell, trade or dispose of cryptocurrency in any way and recognize a gain. Here’s how to prepare.
Did You Gain or Lose on Crypto?
In general, the idea of taking tax losses on crypto before the end of the year is a sound one, said Charles Hwang, partner at Crowell & Moring.
Hwang recommends several steps people should take. First, review where you stand on gains for the year.
“If you used crypto to buy things, you recognized a gain or loss on the crypto,” he said. “If your transactions were complicated, you may need an accountant to help you estimate where you stand.”
The next step would be recognizing losses by selling crypto for which the tax basis exceeds the current market value, he added. “To affect your tax liability for 2022, you must recognize your losses before the end of 2022.”
Finally, Hwang added, if you have crypto assets for which you have losses but there is no market into which you can sell the asset, consider hiring a lawyer to write a contract in which the “benefits and burdens” of ownership are transferred to another person before the end of the year.
What About FTX?
Seth Lebowitz, partner at Sadis & Goldberg, said taxpayers with crypto investments should keep in mind that gains and losses as defined for tax purposes are not always identical to the way investors think about whether they have gains and losses in their investment portfolio.
“For example,” he said, “taxpayers who economically lost some or all of the value of an account with FTX but may have a chance of at least a partial recovery of what they lost, such as through the bankruptcy process, may not be able to claim a loss for tax purposes until their claim in bankruptcy has been resolved.”
Lebowitz added that many taxpayers would benefit from looking at all of their crypto and other investment transactions before the end of the year, identifying gains and losses for the year and determining whether they have any additional economic gains or losses that, if realized, might be beneficial to them in the current tax year.
This could mean selling an investment and either realizing a loss in order to offset a gain from earlier in the year or realizing a gain in order to make use of a loss from earlier in the year, he said. However, he notes that people need to be wary of limits on the deductibility of losses. A common example: If a taxpayer has capital losses in excess of capital gains for the year, the individual is limited to deducting a maximum of $3,000 against ordinary income.
“Clearly a taxpayer would want to keep this in mind before, say, selling an investment resulting in a $20,000 loss in order to offset a $5,000 gain,” Lebowitz said.
He also emphasized the importance of talking with a tax advisor, as crypto has developed faster than the tax law and IRS guidance that applies to it.
“A lack of clear guidance on a particular issue might allow a taxpayer legitimately to take a favorable tax position in the absence of direct guidance supporting it,” he said, “but it can also mean that the IRS could oppose the taxpayer’s position on audit, or publish future guidance that undermines the taxpayer’s position.”
Several experts agree that taxpayers who lost money on FTX might have additional hurdles when filing their taxes this year. While the situation is unfolding, it might take months to get any kind of clarity.
“The collapse of FTX is going to complicate … tax season for a lot of the exchange’s users,” said Jeffrey Blockinger, general counsel at Quadrata.
Blockinger said the most important thing for people who lost money on FTX, or who are unable to access their transaction history on the exchange, is to consult a professional tax preparer.
“Preparing your own taxes is fine if you’re an expert,” he added. “But, again, if you’re not an expert, then definitely consult with a professional tax preparer and be as transparent as possible while doing so.”
The Wash-Sale Rule
The IRS’s wash-sale rule prohibits investors for claiming losses on securities sold at a loss and reacquired within 30 days — preventing taxpayers from using “artificial” losses to offset their gains and lower their capital gains tax liability, according to TokenTax.
Although everyone’s financial and tax situations are different, everyone should at least consider tax loss harvesting on their cryptocurrency investments, said Motley Fool analyst Cody Kaminski, who added that the wash-sale rule has not applied to the crypto industry (yet), meaning investors can retain exposure to their investment while clocking in a loss for 2022.
“There is a chance that the wash-sale rule will apply to the industry going forward, once regulators figure out the best practices,” he said. “For this year, at least, loss harvesting through a wash sale is possible.”
Another option, he added, is to sell a crypto asset and use those proceeds to purchase another one.
“The potential benefits are twofold: The sale will trigger a taxable event. If it’s a loss, it can be recorded on the tax filing,” Kaminski said.
Or, the proceeds could go toward a “better” cryptocurrency investment that can outperform the previous one.
“For example, one might consider selling a meme coin they purchased at the market top and move those proceeds into a decentralized finance token,” he said. “What constitutes a better cryptocurrency depends on one’s investment philosophy, risk profile and thesis.”
Divorce and Crypto Taxes
Finally, another hurdle for taxpayers with cryptos comes in instances of divorce.
Sandra Radna, divorce lawyer and author of “You’re Getting Divorced … Now What?: The Ultimate Divorce Court Guide,” reminds divorcing couples that it’s important for them to know as they are dividing the marital estate that all assets of the marriage, including digital assets, are considered property.
“This year many crypto investors incurred significant losses,” Radna said. “Depending on your tax bracket, divorcing couples can offset any crypto profits earned earlier in the year with the losses they sustained later in the year. The key here is transparency. Both parties must be in the loop and enjoy the benefits of any tax savings. Even if the divorce has been commenced, the soon to be ex-spouses may file jointly until there is a final divorce judgment or decree.”
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