Tag: crypto tax

Categories
business law internet law

Stablecoins 101: What Are They, How Are They Taxed, and Can I Use Them In My Business?

Cryptocurrency has significant business utility, especially in international transactions. Companies can exchange funds directly, without wiring fees or banking delays, and easily convert their native currencies into crypto and vice-versa using a mobile phone. However, traditional cryptocurrencies like Bitcoin and Ethereum are extremely volatile and their exchange values can easily fluctuate 10-20% or more in a matter of days or even hours. Market supply and demand forces determine the prices of these most popular cryptocurrencies and their value is particularly sensitive to various external factors. Events like China’s crypto clampdown, significant buys or sells by capital investors, or even Elon Musk’s tweets can crash the market or send the price of crypto soaring. Obviously, price volatility makes businesses and consumers reluctant to adopt these cryptocurrencies for day-to-day transactions. Price volatility translates into purchasing power uncertainty, which in turn devalues the currency.

Stablecoins are cryptocurrencies that try to solve the volatility problem. They do so by pegging their price to the price of another asset (such as the U.S. Dollar or an ounce of gold). For example, the USD Coin (USDC) can be acquired and sold for U.S. Dollars on a 1 to 1 ratio. USDC is actually backed by existing dollar reserves, meaning that each USDC has a real-world dollar counterpart held by regulated financial institutions. USDC reserves are also periodically verified by a third party (but not audited).

There are other stablecoins as well, for example Tether, Binance USD, TrueUSD, DAI, and more. Like USDC, some are tied 1 to 1 to U.S. Dollar reserves. Others are backed by commodities like gold, silver, or oil. The price of a commodity-backed stablecoin is tied to the market price of a commodity unit, like an ounce of gold. There are also stablecoins that attempt stability through overcollateralization using other cryptocurrencies. Finally, there are algorithmic stablecoins that automatically adjust the cryptcurrency’s supply to keep its market price within certain parameters.

Stablecoins are however still cryptocurrency. Even if the stablecoin has a pegged 1 to 1 exchange ratio with the U.S. Dollar, it is not the same as cash. For tax and regulatory purposes, the IRS treats all cryptocurrency as intangible property subject to capital gains tax. They may be subject to separate state-level regulation as well.

Paying for goods and services in stablecoin is a taxable event because the IRS treats it like a sale or exchange of an asset, which is subject to capital gains tax. Technically, if the stablecoin is pegged to the dollar at a 1 to 1 ratio, the capital gain is 0 and there is no tax owed. But the transaction must still be recorded and reported, just like if you were buying and selling a stock at zero net gain/loss. Otherwise, you risk attracting an IRS audit to determine whether you underreprted taxable income. Buying stablecoin for cash and holding it is a non-taxable event.

Receiving stablecoin in exchange for goods and services is a taxable event. It is not much different than receiving payment in fiat currency, which is income subject to tax. The fair market value of the cryptocurrency as of the date of receipt determines its value for income reporting purposes. With stablecoin, it is easy to calculate because of the 1 to 1 ratio. Receiving 500 USDC is the equivalent of receiving $500 cash. However, spending the 500 USDC is not the same as spending $500 cash – rather, the transaction is considered a liquidation of property (subject to capital gains). Again, if the value of the stablecoin is pegged to the dollar, you are not going to have capital gains. But you must still keep records and record the transaction. If you are using a stablecoin that is pegged to an asset like gold, its price will fluctuate and you may record a capital gain or loss.

Converting other cryptocurrencies into stablecoin and vice-versa is also a taxable event. The sale of the crypto is an asset disposition that is subject to capital gains tax even if the transaction is an exchange of one currency to another. Similarly, using stablecoin to purchase other cryptocurrencies is a sale of the stablecoin that must be reported as income, even if the the capital gain is $0.

Stablecoins are still risky and unregulated. Not all stablecoins are created equal and it is a mistake to think that “stablecoin” means there is no risk involved. The LUNA/TERRA debacle is a good example because TERRA was supposedly a “stablecoin” pegged 1 to 1 to the U.S. dollar, yet it was pegged algorithmically (meaning artificially without any actual assets or fiat currencies backing it). An algorithm that no one really understands is not the same backing as fiat in a vault or money market securities or corporate bonds or commodities portfolios. The bottom line is that without a uniform definition of “stablecoin,” users should at a minimum know what “stabilizes” the value of the purported “stablecoin.”

There are other hurdles to using stablecoins in day-to-day business operations. As cryptocurrency, they are still subject to government regulation. For instance, it is illegal under federal labor law to pay workers in anything other than U.S. Dollars. On the international scene, China recently tightened anti-crypto regulations, prohibiting financial institutions from providing crypto exchange services, which presumably includes stablecoins. At the same time, China is rolling out its “digital yuan,” which is a sovereign-backed virtual currency. United States regulators have also expressed interest in the “digital dollar,” in part to improve financial services access to unbanked or underbanked communities. Additionally, all cryptocurrency transactions are still subject to exchange fees imposed by the intermediaries, and there may be delays or additional processing costs associated with converting stablecoin into fiat currency. Widespread adoption by merchants and the public is a must for stablecoins to develop practical utility – but right now, holding a wallet full of stablecoin is not the most practical or liquid solution for most businesses. Nor does a 1 to 1 dollar stablecoin provide any investment upside and in fact periodically loses value due to inflation.

Finally, there are at least 36 different stablecoins available for purchase via most popular exchanges. It is unknown which stablecoin (if any) will enjoy widespread adoption and popularity sufficient to result in real utility for businesses. Further, stablecoins are not truly decentralized because a central entity is holding the collateral, which in turn must be audited or otherwise verified. If a holding entity starts issuing stablecoins that are not actually collateralized, this would cause hyperinflation and essentially render the stablecoin worthless.

Stablecoin certainly holds a lot of promise for business use, but only solves the problem of volatility. Reduced volatility comes at a cost of a centralized authority and reintroduces trust into the cryptocurrency equation. At the same time, sovereign-issued digital currencies are on the horizon and may very well dispel the need for and demand for stablecoin.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Categories
intellectual property internet law

NFTs: Investing in Virtual Real Estate and Other Digital Assets.

Disclaimer: This article is not investment advice, tax advice, or legal advice. It is for informational and promotional purposes only. Do not take any action (including investments) until you have consulted with a professional about your specific situation.

I have previously written about investing in cryptocurrencies through a self-directed retirement portfolio and about using them in day-to-day business transactions. There is no doubt that crypto and blockchain technology is here to stay. As evidence of this, the U.S. government will increase reporting of and tax enforcement for cryptocurrency transactions, which are currently treated like property for tax purposes, but not the same as stocks or securities. Increasing regulation and taxation certainly indicate how much the technology is being used and adopted across the world.

What about NFTs or non-fungible tokens? There was a lot of buzz in early 2021 about NFTs after Christie’s auctioned off a digital-only artwork for $69 million and suddenly everyone from Nike, to Hasbro, to Cervelo (a racing bike manufacturer) was selling digital-only versions of their collectibles or attaching NFTs to physical world assets. The hype has since subsided, at least from the mainstream media sources. However, spend enough time on the various social media platforms, and NFT proponents (sellers) will be quick to offer “virtual estates,” “one-of-kind avatars,” “priceless digital art,” and various other exotic and futuristic-sounding assets. Often, you will be directed to an auction site where you will have to place bids on the NFT, sometimes even using a native cryptocurrency or token like MANA or SAND.

Suppose you got caught up one night, cashed out your 401k, and bought $100,000 worth of NFTs – a virtual castle in Decentraland, some art tapestries to decorate, and a digital collection of Luka Doncic basketball cards. The next morning at breakfast you have to explain to your spouse – NFTs? WTF did you just buy? Read on.

  1. NFTs as personal or business investments.

Before investing in anything, it is generally a good idea to understand exactly what you are buying. NFTs are digital representations of unique items based on the Ethereum blockchain. When you buy an NFT, you basically just bought computer code. The simplest description of blockchain is that it is a decentralized public ledger or database. Data is entered into a block – in the case of an NFT, it is specific code that signifies the “object” and its owner – and then that data becomes part of the public ledger that is replicated and stored across a vast, decentralized computer network. An NFT can have a real world counterpart, but it does not have to. As will be discussed below, an NFT can be sold together with or separate from the work’s copyright. The “non-fungible” aspect of the token means it is unique and not interchangeable with other items. Traditional fiat currency is inherently fungible because a dollar bill is interchangeable with other dollar bills. Cryptocurrency is also fungible – one Bitcoin is the same as another and has the same value. On the other hand, an original Monet, your grandmother’s jewelry, or even a pair of Nike shoes are all non-fungible because they are unique.

One big difference between NFTs and cryptocurrency is liquidity. One of the reasons why crypto is so popular right now is accessibility. Exchanges like Coinbase make it easy for anyone to buy and sell cryptocurrency right from their phone, while keeping records, and facilitating exchange of almost any cryptocurrency. Whether you want to cash out into fiat dollars to cash out or exchange cryptocurrencies for other cryptocurrencies, you can do it on your phone or computer in a very simple and quick process. NFTs are not as liquid – to sell one you have to find a willing buyer and negotiate a price. For example, OpenSea is a large marketplace for NFTs, allowing listings at auction, fixed price, or declining price settings. The market determines the price of NFTs, meaning supply and demand. In the NFT market, there may be only a couple of willing buyer and sellers, which is quite different from the millions who buy and sell cryptocurrencies every day. Also, tthe Securities and Exchange Commission does not regulate NFTs or most cryptocurrencies at this time. While a company selling stock or bonds on the open market must follow filing and disclosure requirements to ensure a transparent public offering, crypto and NFTs offerors do not. Proceed with caution.

2. What are the legal implications of this “wild west” of NFTs?

NFT investors face two areas of legal issues: copyright law and tax law. Copyright law protects the creator’s rights in computer code, as well as art, music, and other creative works. Tax law is involved whenever you buy, sell, or invest in anything.

A. Copyright.

NFT ownership is not copyright ownership.

When buying or investing in an NFT, it is absolutely essential to understand what it is you are buying – in other word, what “bundle of rights” are you getting in exchange for your cash? In the physical world, when you buy an asset like a painting or a car, you are at least getting the physical thing. In the all-digital world of NFTs, it gets a little bit complex.

Under U.S. copyright law, the creator of art, music, movie, or other creative work owns the copyright, which attaches at the moment of creation. Transferring the physical object alone does not necessarily transfer the copyright with it – a written agreement transferring copyright is required to separate the creator from the copyright. In other words, the physical work and the copyright to that work are distinct and separate. NFTs are no different – the fact that the work is digital or consists of computer code does not matter. There is still the ownership of the original work (piece of code) and the copyright to that work. Do not assume that you are buying the copyright to the NFT when you purchase it on an online auction site unless there is a specific agreement to assign the copyright to the buyer.

If you bought an NFT without the copyright, you essentially bought a unique piece of computer code that you cannot display, duplicate, or republish without the original creator’s permission. You need the copyright to reproduce, copy, license, and otherwise do pretty much anything with the NFT. Creating derivative works based on the NFT likewise requires the copyright. In short, know what you are actually buying, as copyright gets particularly complex in the digital world. An attorney may be needed to review the agreements, especially if the transaction involves a substantial sum of money.

B. Tax.

The IRS issued guidance as far back as 2014 that cryptocurrency is taxed like property and subject to capital gains tax. But there has been no guidance on taxing NFTs. Because NFTs and cryptocurrency rely on the same underlying blockchain technology, it is likely that NFTs will also be taxed like property and subject to capital gains tax. That means if you buy an NFT for U.S. Dollars, you do not pay tax on that transaction (unless a state decides to enact a sales tax on digital assets). But when you sell that NFT in exchange for cash or cryptocurrency, or trade it for another NFT, you have a taxable event. Any “gain” will be treated as reportable taxable income.

It can get especially complex if you involve cryptocurrency in the transaction. Some NFTs can only be purchased in exchange for a specific token – for example, virtual real estate in Decentraland can be purchased only for MANA tokens, which are an Ethereum token. The price of the MANA token fluctuates, just like the price of BTC or ETH or DOGE. If you pay cash for MANA, that transaction is not taxable. But then when you exchange MANA for an NFT, you are “selling” the MANA, taking a capital gain or loss, and then acquiring the NFT at the market price, which establishes the NFT’s cost basis for future transactions. When you sell the NFT for cash, you have a capital gain based on the difference between the cost basis and the sale price. But if you trade the NFT for another NFT or for Bitcoin, you again have a double tax event because you are selling “property” (subject to capital gain at the time of exchange) and acquiring “property” (subject to capital gains at the time of subsequent sale or exchange) at the same time. This is why good record keeping is an absolute must and is especially critical if you are engaging in a large number of transactions.

All of this assumes that NFTs will be taxed like cryptocurrency. But it is possible that NFTs will be taxed differently based on what the NFT represents. Will the sale of digital land be treated as a sale of physical real estate? All of a sudden state transfer taxes may come into play. Will the sale of digital art or collectibles be treated the same as physical art of collectibles and subject to special tax rates? There are many unanswered questions at this time, but as the IRS zeroes in on crypto and blockchain assets as sources of tax revenue, there will certainly be regulation and litigation on this subject.

3. Future applications for NFTs beyond collectibles and investments.

One of the most fascinating things about NFTs and blockchain tech in general is unlimited potential. The decentralization and immutability aspects are extremely potent in a number of applications. For example, in the business setting, smart contracts that automatically enforce performance and payment can eliminate many costs and inefficiencies related to international trade. Escrow accounts and associated fees may very well be a thing of the past. If performance under a contract can be reduced to code and automated, costly contract disputes can be avoided.

Blockchain can also be used in software licenses as well as licenses for other intellectual property. Concert or other event tickets are another application. Corporate governance and shareholder meetings can be accomplished through blockchain – for example, a corporation could issue a token for each share and then ask its shareholders to vote by transferring the voting tokens to a specific address. The transparency and security of the blockchain are especially valuable in this context. Some commentators have even suggested blockchain as a way to secure and democratize political elections. With a publicly-verified chain, election fraud would virtually be eliminated and election results would become indisputable.

Whatever the future holds, blockchain is exciting technology. As with all emerging technologies, the law is an a state of flux. Government regulators are playing catch up to address the application of existing law to new tech and to propagate new laws to address emerging problems. If you are investing in NFTs or using blockchain in your business, contact an experienced attorney to answer your questions and ensure that you are being proactive with your regulatory and tax obligations.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Categories
business law internet law

Ask the Crypto Tax Lawyer: Is Staking Income Taxable?

Yes, staking income – just like most other types of income – is taxable. However, the question is when? When you receive the staking reward? Or only when you sell or exchange the newly- obtained tokens? Under the first, more conservative approach, the token is actually taxed twice – once as ordinary income at the time of receipt and the second time at the capital gains tax rate when it is sold or exchanged. Under the second, more aggressive approach, the token is not taxed upon receipt and not subject to tax until it is sold or exchanged. The second approach also allows token holders to take advantage of more favorable long-term capital gains tax rates by holding the staking rewards longer than a year.

How is Staking Different From Interest?

What is staking? It is an arrangement to “lock up” or “stake” a portion of an owner’s crypto tokens in a staking pool in return for additional cryptocurrency over time. The return is often expressed as a percentage. This makes staking seem very similar to an interest rate paid on a certificate of deposit or savings account. Indeed, on Coinbase, staking rewards are expressed in terms of an APY (annual percentage yield) and the term “interest earned” is used synonymously with staking. Unlike proof-of-work mining, which validates new transactions through solving complex algorithms, staking is more energy efficient and environmentally-friendly. Staking allows network participants to nominate their coins to be used as validators and to guarantee the legitimacy of new transactions on the blockchain. In return for validating a new block, the owner receives new tokens; if the transactions validated are later found to be illegitimate, the validator may lose tokens through a process called “slashing.”

Although it may seem like interest income, staking income may not be taxed the same way. The IRS has not taken a definitive position on this question even as the deadline to file 2021 taxes approaches. One of the reasons may be because of pending litigation in Jarrett v. IRS. In 2019, Josh and Jessica Jarrett sued the IRS for a refund on taxes paid on staking income, arguing that cryptocurrency received for staking should not be. Recently, the IRS appeared to concede that staking income is not taxable at inception and agreed to issue the Jarretts a refund. However, the taxpayers rejected the IRS’s offer – instead, opting to push the Tax Court to make a definitive ruling on the issue and create binding precedent. In response, the IRS has asked the Tax Court to dismiss the case in light of the plaintiffs having obtained full relief and the absence of a “case or controversy” for the Tax Court to decide.

The Conservative Approach – Staking Rewards Are Taxed Twice

Intuitively, it may seem that income from staking should be treated the same as interest/dividend income from a savings account, which is incurred when the bank pays it out. In the crypto context, the IRS has taken a position since 2014 that with mining, the fair market value of the virtual currency as of the date of receipt is includible in gross income. Arguably, staking income is sufficiently similar to interest earned or mining to be treated the same. Depending on the terms of the staking arrangement or agreement, the cryptocurrency or token contributed is restricted much in the same way that cash in a certificate of deposit is locked in until maturity.

The Aggressive Approach – Staking Rewards Are Only Taxed When Sold or Exchanged

However, the counter-argument (and the taxpayer’s position in the Jarrett case) is that the tokens received as a staking reward have no value until they are sold or exchanged. In that sense, they are like manufactured product that may have value when created, but is not taxed until it is sold. The product has a market value when created, but the IRS does not impose a tax on it at the time of creation.

Further, fiat currency has tangible value when received – an interest payment of $25 has worth and buying power at the time of receipt. It does not need to be sold or exchanged to have value. Conversely, 100 Tezos tokens (at issue in the Jarrett case) have no buying power or value until and unless they are exchanged into fiat, traded for another currency, or used to pay for services. Yes, if you pay for services with cryptocurrency, you are taxed on any difference between the basis and the fair market value of services received. According to the IRS, if you buy 100 Tezos for $1 (a basis of $100) and then exchange those same 100 Tezos for $300 worth of legal services, you just realized a $200 taxable gain. Proponents of the more aggressive Jarrett approach argue that cryptocurrency or tokens received as staking rewards are more analogous to a manufactured product than fiat currency interest or dividends.

The Issue Remains Unsettled

To complicate the issue further, the IRS’s offer to refund the Jarretts’ tax and settle the litigation seems like a tacit endorsement of the second, more aggressive approach. Arguably, the IRS is conceding the issue and admitting staking income is only subject to income tax when sold or exchanged. However, this position is directly at odds with the IRS’s guidance on tokens received from mining. The IRS’s Notice 2014-21 on virtual currency taxation states that “when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.”

While the issue remains unresolved, taxpayers should consult with their legal and financial advisors on the correct approach for them. The conservative approach risks including too much in your gross income. The aggressive approach risks underpayment penalties in the future if the IRS does issue guidance and takes the same position on staking as it has on mining. But in any case, keep an eye on the Jarrett case, as the Tax Court may rule on this very question in the near future.


Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

Categories
business law gaming law internet law

Ask the Crypto Tax Lawyer: Are Play-to-Earn Games Taxable?

Disclaimer: This article is not investment advice, tax advice, or legal advice. It is for informational and promotional purposes only. Do not take any action (including investments) until you have consulted with a professional about your specific situation.

At the end of 2021, Ubisoft announced its plans to add NFTs (Non-fungible Tokens) into Ghost Recon: Breakpoint. Players’ in-game weapons, vehicles, and other rewards will be tradable and sellable on a secondary market, adding a real-world value component to the game. Ubisoft will become the first mainstream videogame developer to incorporate NFTs into its video games, although other A-list developers like SquareEnix are also planning to transcend the virtual and real worlds through blockchain technology.

Ubisoft follows in the wake of some popular Play-to-Earn (P2E) games like the global sensation Axie Infinity. According to a January Business Insider article describing the P2E crypto gaming model, Axie Infinity increased the value of its native AXS cryptocurrency (an Ethereum token) by a staggering 18,000% in 2021. Metaverse platforms that promise fully functional virtual worlds in the near future like Decentraland and Sandbox also saw explosive growth. For example, Decentraland’s native MANA token increased in value by 4000%. The main draw of these virtual worlds is that they allow users all over the world to earn cryptocurrency and NFTs that tradable for mainstream crypto or fiat money. Obviously, the returns and growth potential have captured the attention of many.

However, real world earnings mean real world taxes. As crypto and NFT earnings become more and more mainstream, more tax payers will have to consider the tax implications of cryptocurrency. The IRS considers cryptocurrency to be property, which is subject to capital gains tax similar to stocks or bonds. While the IRS has had guidance on cryptocurrency transactions since 2014, NFTs are a much more recent phenomenon without official guidance. Which then creates a number of questions for P2E players about how their winnings are reported and taxed.

Do I owe taxes on my play-to-earn winnings?

Absolutely. Because play-to-earn games allow users to earn cryptocurrency or NFTs, which then can be exchanged for fiat currency (e.g. U.S. Dollars), these earnings are considered income. In general, real world earnings mean real world taxes; however, the way your earnings are taxed will depend on several different variables.

To understand how the IRS will tax play-to-earn gains, you must first apply a few basics:

Are all P2E earnings the same?

No. Although both cryptocurrency and NFTs exist on the blockchain, they are two very different things and have different tax implications. Non-fungible tokens or NFTs are unique digital-only objects or unique digital versions of real-world objects. This is basically computer code. Mostly associated with collectibles and art, NFTs use blockchain technology like cryptocurrency but can represent almost anything, including virtual real estate, in-game vehicles or weapons, and personalized avatars. In the case of Ubisoft’s Ghost Recon, the “in-game earnings” will be in the form of NFTs. Similarly, the Pokémon-like Axie creatures that players acquire in Axie Infinity are also NFTs. These in-game items are pieces of unique computer code stored on the blockchain. These NFTs can later be exchanged for other NFTs or cryptocurrency.

Cryptocurrency, however, is not a unique collectible, but rather, a virtual currency. The IRS, in its Frequently Asked Questions on Virtual Currency Transactions, defines crypto as a type of virtual currency or “a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.” Play to Earn games like Axie Infinity will commonly use crypto. In fact, Axie Infinity, much like Decentraland (which is more of a general attempt at a metaverse, rather than a stand-alone game), developed its own crypto token (AXS). AXS is tradable and exhcnagable into more mainstream currencies like Bitcoin or Ethereum (which are easily convertible into fiat), giving them value – not only within the game sphere itself – but also within the real world.

How do P2E gamers make money?

To fully understand taxes, it is first important to understand the basics of the P2E economy. Play-to-earn games give players an opportunity to win both cryptocurrency and NFTs by playing a game. Most often, the game will use its own native token as an in-game currency. The in-game currency and NFTs have value on the secondary trading market. To use Axie Infinity as an example, a player can earn value in several different ways:

  • First, a player acquires NFTs known as SLPs (Smooth Love Potions) through monster battles, player versus player fights, or by completing daily missions and quests. The player can then exchange those potions for cryptocurrency or even cash by selling them on an NFT exchange or DEX.
  • Second, a player can use SLPs to breed rare magical creatures (NFTs) known as Axie. Depending on the Axie’s traits and characteristics, an Axie NFT can fetch $200 or more on the secondary market.
  • Third, a player can stake AXS tokens in exchange for a particular return rate. Staking with crypto tokens is akin to holding money in a certificate of deposit (albeit, much riskier).
  • Finally, the game may award tokens or NFTs via airdrops. Airdrops are giveaways that the game may send its players as part of random promotions or in return for doing specific tasks.

What (and how) the game pays the player determines the type of taxes that particular player will owe. Is the income in the form on an NFT? Tokens? Staking income? An airdrop?

Are there taxes on tokens?

Whether it is called a token, cryptocurrency, or virtual currency, a native game token is taxed like intangible property and is subject to capital gains tax. The IRS has had a consistent position on this since at least 2014. When you purchase cryptocurrency or tokens with fiat currency (e.g. U.S. Dollars) you do not pay tax on the transaction. So if you buy AXS directly for USD, this is not a taxable transaction. However, if you buy AXS for ETH or BTC or another cryptocurrency, stablecoin, or token, you have incurred capital gains because the IRS considers you to have sold cryptocurrency you have traded – even if the transaction is a direct exchange.

If you earn crypto tokens as a part of a Play-to-Earn game, the value of such crypto is taxable as ordinary income. Likewise, when you sell crypto tokens on an exchange, you are taxed on the gain (if any) just like you would be if you sold a stock or investment real estate. Again, when you exchange one cryptocurrency for another (for example, you buy AXS with stablecoin) the exchange is taxable. Accordingly, it is critical to keep accurate and clear records of every transaction involving cryptocurrency, regardless of gain or loss.

How are NFTs taxed?

The IRS has not issued definitive guidance on how NFTs will be taxed, but most experts agree that NFTs will probably be considered property like cryptocurrency and be subject to capital gains tax. When applying this framework, NFT investing generally involves three different taxable events:

  • The Purchase of a NFT with Crytpocurrency. Play-to-Earn games often require a buy-in. Axie Infinity, for example, requires players to buy three Axies to start, which currently costs around $1,500. If you “buy-in” with cryptocurrency like ETH, the IRS will consider you having sold the ETH and have earned income equal to the difference between your purchase value and sale value. The acquisition of the NFT itself is not taxable for the buyer – but, is taxable for the seller as income.
  • The Sale of the NFT in exchange for Crypto. Selling an NFT creates a taxable capital gain or loss equal to the difference between purchase and sale price. Simply put, if you bought an NFT for $1,500 and sold it for $2,000, you incurred a $500 gain. If you bought the NFT for $1,500, but sold it for a $1,000, you have a $500 loss that you can use to reduce your other capital gains or even your ordinary income up to a certain amount.
  • The Exchange of the Crypto proceeds for U.S. Dollars or other fiat currency. Like the sale and purchase of NFTs, the exchange of a cryptocurrency into USD or other fiat currency will also trigger a taxable capital gain or loss depending on the difference between the original purchase price of the cryptocurrency (or token) and the price at the time of its sale.

Currently, there are no tax exemptions or safe-harbor periods that allow traders avoid capital gains tax on exchange type transactions.

Are NFT investors taxed differently than NFT creators?

Yes. Let’s say you’ve found a way to farm massive amounts of SLP (Smooth Love Potions) in Axie; these are NFTs. The initial creation or the minting of the NFT is not a taxable event. However, the sale of the NFT is taxable. However, in this case, since you are the creator and also the seller, and you technically “did the work” to earn the NFT, the IRS will likely consider the proceeds from your NFT sale ordinary income for tax purposes.

Is staking taxable?

Yes. Sure, my staked sheep in Wolf Game owe a 20% tax to wolves on all sheered WOOL; everyone knows that. But do I also have to pay WOOL taxes to the US government? Yes. Many taxpayers currently consider staking the same as crypto mining income, which means they will owe taxes on the fair market value of the WOOL the moment they receive the WOOL in their wallet – not just when they sell it.

The IRS is currently in litigation regarding this issue. The question being considered is whether the cryptocurrency or token has taxable value at the time of minting ( in my case “shearing”) or whether it should be taxed only upon sale of the WOOL – similar to the way traditional manufacturing companies operate. (For example, factory owners don’t pay income tax on a manufactured table, even though that manufactured table holds value, until the table sells.) This is one of the many unanswered questions in the blockchain sphere that regulators are catching up to answer.

Are Airdrops Taxable?

Yes, generally airdrops are considered ordinary income based on the fair market value of the drop at the time you get it. As with everything else, crypto-related, be sure to keep detailed records of all your crypto transactions to make sure that you account for them properly.

So, Do I Owe US Taxes on My Earnings from Play to Earn Games?

Yes. Real world earnings mean real world taxes. Whether you earn NFTs, native tokens, or Bitcoin, those assets have value and therefore subject to income tax. You, as the taxpayer, are still obligated to report income just like you would be if the game paid you in stock. As always, it is important to consult a crypto tax expert to see how the specifics of your situation apply to current IRS guidelines.

Further reading:

https://artaevatlaw.com/2021/10/05/play-to-earn-games-legal/
Is Playing Video Games for Real Money Legal? It May Depend on the Game.
Ask the Crypto Tax Lawyer: What Are the Tax Implications of Cryptocurrency and NFT Investing?
Categories
business law internet law

Ask the Crypto Tax Lawyer: What’s New for ’22?

2022 is a marquee year for anyone who took got involved in cryptocurrency during the 2021 market boom. The start of the new year means the start of tax preparation season and many individuals and companies are working to understand the tax treatment and implications of digital asset investments. In 2021, the IRS and the Department of Treasury announced increased efforts to track cryptocurrency transactions and enforce the perceived underpayment of tax in the crypto world. However, the government’s guidance has been limited. There are many uncertainties and questions in this evolving area of law. Read on for a summary of the key issues:

Cryptocurrencies Are Taxed As Property Subject to the Capital Gains Tax.

In the ever-changing world of crypto, one thing has stayed the same (since at least 2014): Cryptocurrency is property subject to the capital gains tax. In its FAQ guidelines, the IRS addresses a number of situations (such a hard forks and airdrops) to explain its position on basis and gain/loss calculation. If you received, sold, exchanged, or otherwise disposed of “any financial interest in any virtual currency,” the IRS requires you to disclose this on the first page of the 1040. If you check “yes,” expect to file a 1040 Schedule D (“Capital Gains and Losses”) and an 8949 supplement.

What does this mean in practice?

  • If you bought cryptocurrency in 2021 for cash and are holding it (or HODLING), there is no transaction subject to capital gains and nothing to report.
  • If you sold cryptocurrency for cash, traded crypto for another crypto, used crypto to buy an NFT, or paid someone for goods or services using crypto, you have a reportable capital gains transaction. The “gain” is the difference between the initial value (basis) and the sale value. If the period between acquisition and sale is less than a year, the short-term rate applies, which treats the gain as ordinary income. If the period is more than a year, the long-term rate applies and is either 0%, 15%, or 20% depending on your annual income level.
  • Exchanging crypto for other crypto (for example, you exchange BTC for ETH) is also subject to capital gains tax. The IRS treats the exchange as if you sold BTC for cash and used that cash to buy ETH. That means that any “gain” you realize on the sale of BTC is reportable and taxable, even if you use 100% of your proceeds to buy another cryptocurrency.
  • If you use crypto to buy an NFT or pay for some other goods or services, the IRS treats the transaction as if you sold the crypto for cash (incurring a capital gain) and then used the cash to buy the NFT or pay for the other goods/services.
  • What if my corporation or LLCs bought, sold, or exchanged virtual currency or digital assets? There is no guidance to suggest that business entities are treated any different. Record and report crypto and other digital asset transactions like you would physical property or assets.
  • Best practice remains to record all of your cryptocurrency transactions in a spreadsheet or accounting software, including the type of asset, the basis price, the date, and any gain/loss (as well as transaction fees). Alternatively, bigger exchanges like Coinbase make reports available to their customers and integrate with several popular crypto tax reporting platforms.

The IRS Has Not Issued Guidance on Taxing NFTs, Utility Tokens, Security Tokens, or Any Other Types of Digital Assets.

What about NFTs? Or utility tokens that you may have bought and sold as part of a play-to-earn game? Or security tokens (STOs) that becoming a corporate financing alternative for high-tech startups? The IRS has not issued guidance or taken a position on any of these particular instruments. In its FAQ, the IRS defines “virtual currency” as follows:

 Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.  Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency.  The IRS uses the term “virtual currency” in these FAQs to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency.   Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes. 

https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions

Although this definition gives some guidance on the IRS’s position, it is still not clear whether NFTs and non-cryptocurrency tokens are “virtual currency.” For instance, NFTs (non-fungible tokens), represent a wide range of things. They can be art or basketball trading cards, but also can be virtual metaverse real estate or video game magical items. Some commentators have suggested that NFTs will be taxed at the 28% “collectibles” tax rate – but that hypothesis presupposes that all NFTs are “collectibles,” which is simply not true for all NFTs. At the same time, the IRS’s definition of “virtual currency” appears to require the asset to be used as a “medium of exchange,” which is also not true of all NFTs. At this time, the NFT tax analysis is best done on a case-by-case basis, with a careful evaluation of what the NFT represents and how the real-world equivalent would be taxed.

Utility tokens are digital tokens that have non-investment uses (or utility) and fall outside of the federal definition of “security.” Play-to-earn video games (like Axie Infinity and its imitators) use native digital tokens for in-game currency and rewards, but the tokens can also be bought and sold on a secondary market. These tokens are more in line with the IRS’s “virtual currency” definition – and while the IRS has not expressly opined that utility tokens are property subject to capital gains tax, they most likely are. In other words, keep records and be prepared to report your sales and exchanges at tax time.

Security tokens (security token offerings are called STOs) are the digital equivalent of traditional corporate financing instruments like SAFE notes or seed round equity. However, the IRS does not consider STOs (or any other tokens) as stock or securities, even if the Securities and Exchange Commission (“SEC”) does. In other words, you sell or buy a security token, you must do so either as a registered security or one that meets an exemption (for example under Regulation A+, D, or S). However, neither the investor nor the selling company gets to claim any sort of tax benefit from the “security” token – because the IRS likely treats it as property and not securities. This means that when you invest in a security token (even one that is registered with the IRS), the tax breaks or advantages that apply to the purchase and sale of stock do not apply.

The Wash Sale Rule Still Does Not Apply to Cryptocurrency, But Might Apply Next Year.

There is a silver lining to the fact that cryptocurrency (or other tokens) are not considered “securities” for the purposes of tax law. The wash sale rule does not apply to crypto and allows for loss harvesting to offset capital gains (and even up to $3,000 of ordinary income.) For example, right now crypto markets are down from their highs and many investors may be showing a loss. If you sell at a loss and buy the asset back immediately, you can claim the “loss” on the sale on your taxes. The wash sale rule – which is applicable to securities – requires a 30 days period before repurchasing the same or substantially the same security.

Congress is aware of and is working on closing this so-called “loophole,” but right now the wash sale rule likely does not apply. It is unclear whether you will be able to claim a loss on 2022 returns if you sell at a loss in 2022, but as of the date of this article, crypto investors can still take advantage of loss harvesting opportunities.

The 2021 Infrastructure Bill Has Not Killed Cryptocurrency.

In the summer and fall of 2021, there was a lot of concern in the cryptocurrency community over certain reporting requirements that Congress wanted to impose on cryptocurrency market participants. Although much of the “hype” was overblown, the main issues were with the new reporting requirements, the definition of “broker,” and how the reporting requirements would affect miners and other participants who are not in the direct sales business.

President Biden signed the Infrastructure Investment and Jobs Act on November 15, 2021, and needless to say, the U.S. cryptocurrency markets are very much alive and functioning. The Act extended the $10,000 cash reporting requirements to “digital assets” transactions, meaning that businesses that receive more than $10,000 in cryptocurrency have to file a Form 8300 with the IRS. The form requires the disclosure of the payor and payee’s name, address, Tax ID, and other information.

The new reporting requirement will not take effect until 2024. By then, expect the IRS and the Treasury Department to develop regulations and provide guidance to market participants, so stay tuned for future developments in this area. It is likely that the scope of the regulations will be limited, as $10,000+ crypto and NFT transactions are much more common than cash transactions, and (unlike cash) also may take place without the parties ever even seeing each other or meeting.

Additional regulation of digital assets in the U.S. is to be expected given their popularity and increasingly prominent role in the economy. However, the U.S. is not about to “outlaw” cryptocurrency, NFTs, token, or any other digital assets. The blockchain tech market is alive and well, but with better defined taxation and regulation may even become more mainstream.

The bottom line is that cryptocurrency markets and derivative digital assets are here to stay. Regulation is constantly evolving and there are many uncertainties for investors and companies working in this emerging market in 2022. Professional legal guidance is always a good idea.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

Categories
business law internet law

What Every Business Owner Must Know About Cryptocurrency Systemic Risk

Whether your business is a full-scale investor in cryptocurrency and blockchain technology or whether you are simply using cryptocurrency to diversify your balance sheet or facilitate international transactions, you are assuming systemic risk. Systemic risk is basically the risk that the “system” in question will fail. The 2008 financial crisis is a recent example of the financial system’s failure due to overleveraged institutions and opaque and risky lending practices. Cryptocurrency and blockchain tech are quickly growing and becoming an integral part of the global financial markets – essentially evolving into another system. For example, sophisticated investors can self-direct their retirement accounts into cryptocurrencies and stake their entire savings on this growing tech.

Risk is part of any business. However, so is effective risk management, which particularly critical in the blockchain/cryptocurrency context, which operates outside of the safeguards and regulatory oversight common to traditional financial institutions. At the same time, existing tax, securities, commodities, and finance regulations still apply to crypto, and compliance is critical to the smooth functioning of your business. At a minimum, any business involved with blockchain tech should involve an experienced business attorney to develop their internal risk management protocols and have a plan for legal compliance, as well as systemic risk.

1. Existing Tax, Securities, and Other Laws Still Apply to Cryptocurrency.

First, and foremost, cryptocurrency is an asset and blockchain enterprises are businesses that are subject to general state and federal laws. While there is no central authority in the United States responsible for policing crypto markets, that does not mean that crypto business operate independent of the law. Government regulators are playing catch-up, and have repeatedly asserted their authority over cryptocurrency and related tech under existing laws. For example, 2020 was the first year that the IRS asked taxpayers about their crypto holdings. Enforcement units are gearing up to address tax evasion and close the multi-million dollar gap between actual income and what is reported to the IRS. The SEC and CFTC are also stepping up enforcement actions to head off fraudulent activity and lack of transparency in certain financial offerings. The Department of Treasury (through FinCen) is also stepping up oversight to enforce existing anti-money laundering frameworks.

The existing regulatory framework is far from perfect and is not well-suited to the unique characteristics of cryptocurrency. For example, why are some ICOs (initial coin offerings) securities, but established coins like Bitcoin and Ethereum are not securities? Capital gains taxes apply to cryptocurrency and stablecoins. But the IRS has not issued any guidance on NFTs. Are they going to be taxed like “property” or like collectibles, art, gold bullion, or something else? Will NFT tax rates depend on what the NFT is supposed to represent?

Stablecoins are a whole separate issue. Recently, a group of Treasury, SEC, and CFTC officials urged Congress to pass legislation to regulate stablecoins. In the “Report on Stablecoins,” the group noted existing SEC and CFTC authority to regulate these markets, but urged reform and legislation that is specific to the new technology.

For investors and innovators, legal compliance is the essential first step. Nothing stifles innovation like an IRS audit or an SEC investigation. Make sure to consult with an experienced attorney for guidance on the latest state of the quickly changing law in this area.

2. Decentralization Does Not Mean Risk-Free or Safe.

Second, the decentralized nature of cryptocurrency and blockchain tech in general lends itself to a false sense of security among investors and businesses. Some crypto advocates consider regulation unnecessary because blockchain tech is “decentralized.” The public ledger system purportedly means total transparency, equity, and fairness. In reality, a decentralized system is not immune from tampering or malfeasance.

For example, blockchain at its core is software that depends on coders and engineers upgrading the “chain,” fixing bugs, and making improvements. Someone somewhere determines forks and chain upgrades. Also, what about miners? What precludes off-chain influence (i.e. bribes) to miners that would impact the whole chains or cause them to verify certain blocks or transactions out of sequence?

Stablecoins are considered “safe” because the tokens are purportedly backed by fiat or equivalent reserves. But there is a lack of transparency between various stablecoins, different liquidity thresholds between reserves (for example, cash vs. money market vs. short term bonds), and variable redemption mechanisms and minimums. Additionally, is your stablecoin of choice based on a public blockchain or a permissioned blockchain? Permissioned blockchains limit access to the blockchain, providing more certainty as to who is responsible for the chain’s operation and integrity. At the same time, they reduce transparency and accountability.

Further, the federal government does not insure stablecoin or cryptocurrency deposits. If you stake cryptocurrency for a return, you are not insured or protected against the coin’s failure, a run, or illiquidity. If you are using a stablecoin to facilitate DeFi transactions, have a plan in case of network problems, chain disruptions, or backing failures. For instance, use several stablecoins to diffuse the risk.

As illustrated by the recent examples of the SQUID token and the Evolved Apes NFT, crypto tech is full of bad actors. The chain itself is not immune from malfeasance. Any business that fully depends on the integrity of the blockchain for its day to day operations must have safeguards. At a minimum, a crypto company must have a robust security system and team dedicated to detecting network health and chain anomalies. Financial hedging that diffuses the risk over multiple chains, cryptocurrencies, and other assets is also critical. Finally, established and documented due diligence protocols to assure investors, regulatory authorities, and lenders are a must.

3. Do Not Take the Internet For Granted.

Third, there is an inherent systemic risk to anything that depends wholly on the operation of the internet. Outages of certain sites or even network-wide service providers are not uncommon. Just recently, Facebook and Instagram were down for almost a full day. Comcast made headlines for its network outages across the United States on November 9, 2021. Directly related to cryptocurrency markets, exchanges like Coinbase have connectivity issues and other disruptions in times of market volatility. This can have direct adverse financial consequences for a business that depends on access to the crypto markets.

Due diligence protocols and internal safeguards are essential in this context. Offline copies of books and ledgers, at least backing up transactions history on a periodic basis. If you are storing crypto, look into offline (hardware) storage options for your code and data. Consider hedging and diversification.

Most important of all, have a plan. Cybercrime and ransomware insurance options are also worth looking into. Crypto and blockchain are existing, but are not without substantial risk. While government regulators are playing catch-up and are urging Congress to pass a risk control framework, legislation is not an instant process. In the meantime, plan for systemic risk as part of your business plan.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Categories
business law internet law

Stablecoin Taxation and Securities Regulation: What Every Investor Must Know.

Stablecoins are cryptocurrencies backed by other assets like fiat currency reserves, precious metals, commercial paper, and even portfolios made up of other cryptocurrencies. By pegging their value to another asset, stablecoins attempt to decrease price volatility and achieve a more “stable” price than uncollateralized cryptocurrencies like Bitcoin and Ethereum. As I previously wrote, stablecoins may be particularly useful for international trade and business due to their predictable value and the ability to avoid wire delays and to minimize transaction costs. Stablecoins are also not targets of speculation or artificial price increases due to external events like Elon Musk’s SNL appearances or even China’s clampdown on Bitcoin mining. If the stablecoin is pegged to the value of the dollar, it will still be worth $1 regardless of whether there is a sudden spike in demand or supply.

Other than potential business use, stablecoins are also a popular investment medium. Certain exchanges have offered attractive interest rates on stablecoin holdings, ranging from Coinbase offering 4% on USD Coin (USDC) to double-digit returns on some lesser exchanges and stablecoins. As always, do your due diligence and make sure you know where your money is going before transferring any significant amount of cash. Also, it may be worthwhile to test the liquidity or withdrawal time with smaller deposits before investing any large amounts.

Just like with traditional cryptocurrency, there are two main legal areas that affect stablecoins: tax and securities regulation. Here are the latest “must knows” in each area:

Stablecoins are taxed like property and are subject to capital gains tax. Cryptocurrency is not “currency” as far as the IRS is concerned – rather, for taxation purposes, it is treated like property and subject to capital gains tax. This gets tricky, especially with stablecoins that are pegged 1:1 to the dollar. Buying stablecoins (or any crypto) for dollars is not a taxable event. However, using stablecoins to purchase goods and services is a taxable event that must be reported, even if your capital gains are zero.

For instance, if you buy 1,000 USDC for $1,000, that is not taxable. Then, when you pay a Romanian engineer 1,000 USDC in exchange for a circuit board design, the IRS deems that you have sold the USDC at the market rate in exchange for the engineering services. The difference between your cost basis and your sell price is the capital gain. Where the stablecoin is pegged 1:1 to the dollar, the capital gain will be $0 (your purchase price and sale price are the same). In fact, you may even realize a loss that you can use to offset your income if you paid a transaction fee. Transaction fees are added to your cost basis, so if you paid a $10 transaction fee to buy 1,000 USDC, your cost basis is $1,010 and when you sell for $1,000, you just netted a $10 loss. Also, you can end up with capital gains or losses if you are transacting large amounts of stablecoin – for example if you sell 50,000 USDT (Tether) when it’s price fluctuated slightly to $1.01, you just received a $500 capital gain.

Additionally, if you are earning interest on your USDT holdings, interest is taxable like ordinary income. In other words, buying stablecoin for fiat currency is not taxable, but earning stablecoin through staking is taxable. Just like you pay income tax on interest earned from your savings account, you will incur income tax on cryptocurrency gains. Finally, when you use your earned USDT to buy something or convert to cash or another cryptocurrency, that is a reportable taxable event subject to capital gains tax because for IRS purposes, you just sold property – your cryptocurrency.

Some stablecoins may be regulated like securities. The Securities and Exchange Commission (SEC) enforces U.S. securities laws, which apply to a wide range of publicly-available investment products like stocks, bonds, mutual funds, and investment contracts where investors provide capital in exchange for expected returns. Cryptocurrencies like Bitcoin and Ethereum are not considered securities because they are exchange mediums and in the SEC’s view, are no different than a foreign currency like the Euro or the Japanese Yen. At the same time, the SEC has scrutinized new coin offerings (also called initial coin offerings or ICOs) and concluded that they may constitute investment contracts if there are facts that indicate the buyer is “expecting a profit to be derived from the efforts of others.” See generally SEC v W.J. Howey Co., 328 US 293 (1946) (where the Supreme Court held that shares in a citrus grove operation were investment contracts subject to securities laws because the investors provided capital with the expectation that workers’ efforts in harvesting oranges would yield profits). Certain stablecoins, especially those that seek capitalization through ICOs and promise a percentage return through “staking,” will be considered “investment contracts” required to register with the SEC and provide public information like any other security.

There are also some stablecoins that are backed by securities like corporate and municipal bonds, mutual funds, and other publicly-traded instruments that are themselves regulated by the SEC. There is little doubt that these security-backed stablecoins are considered derivatives because their value is derived from the value of regulated securities. SEC regulation will require stablecoin issuers to disclose additional information about their companies to the public. Already there is some concerning information release ahead of Circle’s (the issuer of USDC) intent to go public – USDC reserves are only61% cash and money market funds, with the rest divided between U.S. and foreign treasury bonds, municipal, and corporate debt. Previously, the 1:1 stablecoin issuers represented that each coin was backed by actual cash reserves, which were regularly audited. Apparently, that is not the precise reality.

Finally, stablecoins are also facing increased regulatory scrutiny from central bank authorities. Federal Reserve officials have expressed their concerns about the effect of stablecoins on the credit markets. Stablecoins also threaten the ability of the Federal Reserve to regulate monetary supply to stimulate the economy and control inflation. For instance, if a coin like USDC gains widespread adoption, a private company like Circle will be able to regulate monetary supply by increasing and decreasing interest rates. Expect to see increased guidance and regulation from the U.S. Treasury and the Federal Reserve in the near future. It would not be surprising to see stablecoin issuers to be treated as banks in certain circumstances.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Categories
business law internet law

Ask the Crypto Tax Lawyer: Offsetting Capital Gains Through Loss Harvesting.

Update: As of November 10, 2021, Congress is in the process of considering legislation to preclude loss-harvesting through cryptocurrency sales. Congress is also considering other amendments to the Tax Code and other laws to address cryptocurrency specifically. As this is a rapidly developing issue, it is critical that you consult with a tax attorney or other professional about your specific situation and the current state of the law before making any transactions or business decisions.

More than half-way through 2021, cryptocurrency remains an extremely popular investment. Although volatile and subject to unpredictable regulation (yes, that means China), the market has experienced substantial growth. Exchanges like Coinbase and integration with PayPal make owning, trading, and speculating in cryptocurrency easy. Sophisticated investors have even added cryptocurrency into their self-directed retirement portfolios, banking on the continued growth and popularity of the decentralized exchange medium.

As I have previously written, the IRS is keeping a close eye on cryptocurrency investors, transactions, and markets, looking to capture taxes on hundreds of millions in underreported or unreported income. In other words, crypto taxes are going to be an issue for many in the coming tax years, especially after the Biden administration’s mandatory $10,000 or more transaction reporting rule goes into effect in 2023. However, with proper planning and strategy, there are ways to reduce your tax liability even if you are planning to liquidate your crypto positions in the near term.

As a basic matter, know that the IRS classifies cryptocurrency as “property,” which means that it is subject to capital gains tax. General capital gains reduction strategies work for cryptocurrency as well as they do for more traditional property like investment real estate, stocks, and bonds. For instance, waiting at least 365 days to sell lets you take advantage of the lower long-term capital gains tax rate. Selling in a lower income year where your overall income puts you in a lower tax bracket is another strategy.

One advanced tax strategy involves taking advantage of the so-called wash sale rule. Or rather, it is taking advantage of the fact that the wash sale rules does not apply to cryptocurrencies (yet). Under Treasury Regulation 26 CFR 1.1091-1, an investor cannot sell “stock or securities” at a loss, use the loss to reduce taxable income, and then immediately repurchase the stock or security. Under the wash sale rule, there is a 30-day waiting period before purchasing the same or substantially the same stock or security – if an investor repurchases the security within the 30-day restricted period, the loss will be added to the cost basis of the repurchased security and reduce capital gains on the sale of the repurchased security, but it will not be treated as an investment loss to reduce general tax basis. In other words, you cannot manufacture losses in a bear market to reduce your taxable income that you receive from other investments, rentals, or wages.

The IRS has been clear that cryptocurrency is treated as “property” for tax purposes. However, whether it is a “stock or security” remains unanswered and both IRS Notice 2014-21 and the recently amended FAQ are silent on the issue. There is no express definition of “stock or securities” for the purposes of the wash sale rule. Looking elsewhere in the Internal Revenue Code, the definitions of stock and securities in various other sections include traditional shares, notes, bonds, and the like. Indeed, in 1988 the United States Tax Court adopted a narrow interpretation of the Code, holding that stock options were not considered “stock or securities.” Gantner v. Commissioner (91 T.C. 713 (1988). Congress responded by amending the wash sale rule to expressly include stock options, but still did not enact a definition of “securities” for the purpose of the rule.

Based on the current Code and Regulations and the lack of IRS guidance on the issue, there is a strong argument that cryptocurrencies are not “stock or securities” for the purposes of the wash sale rule. What this means is that crypto investors can take advantage of loss harvesting to accrue losses and use those losses to offset income. For example, if you buy one Bitcoin for $30,000 and the next day the price drops to $20,000, you can sell the Bitcoin at a loss of $10,000, “harvest” the loss, and repurchase the Bitcoin for $20,000 shortly thereafter. You still own 1 Bitcoin, but now you have accumulated a loss that you can use to offset capital gains income.

If your losses exceed capital gains, you can use up to $3,000 of loss to reduce regular income. Any excess loss can be carried over to future years to offset future gains.

At the same time, the Securities and Exchange Commission (“SEC”), the Commodities Futures Trading Commission (“CFTC”), and certain United States courts have ruled that cryptocurrencies are indeed “securities” within those Commissions’ regulatory scope. This regulatory effort was generally to stem the fraud and abuse through “initial coin offerings” or ICOs that sought to evade strict regulations designed to protect investors. While there is currently no indication that the IRS would consider cryptocurrency as “stocks or securities,” there is precedent for that conclusion from these other agencies and remains possible that the IRS could issue supplemental guidance and interpretations to that effect.

At the time of this writing, the IRS has not issued any such interpretation and savvy investors can consider the loss harvesting strategy if appropriate for their particular situation. As with all cryptocurrency transactions, good record keeping is paramount. It is especially critical to have accurate records to substantiate your losses if you are repurchasing the same crypto. Good and accurate records are the best tool in defending your position to the IRS, should the IRS take a position and disallow your claimed losses.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Categories
business law internet law

Ask the Crypto Tax Lawyer: How Can I Reduce My Crypto Taxes?

Important: The information in this article applies to individual investors and LLCs that are taxed as pass-through entities. The rules are different for corporations and LLCs electing to be taxed as a corporation and are not addressed here. This article is for informational and promotional purposes only and, as always, you should consult with a professional about your specific tax situation before taking any action.

Despite its name, cryptocurrency or “crypto” is not really currency. For tax purposes, it is treated as “property,” which means it is taxed similar to stocks and bonds. As I previously wrote, buying and selling crypto is subject to capital gains tax. Paying for goods and services with crypto is likewise subject to capital gains tax. Exchanging one crypto asset for another is a taxable event as well.

“Crypto tax” has a nice ring to it, but it is nothing more than the application of ordinary capital gains tax to cryptocurrency transactions. The most important aspect of crypto investing – whether individually or as part of a business – is good record keeping. Exchange platforms like Coinbase can generate basic reports to use at tax time. But remember that you must also keep records when you pay for goods and services with crypto or receive payments in crypto. For tax purposes, when you pay someone in Bitcoin or Ethereum, the IRS considers that you have sold the cryptocurrency for cash (and realized a capital gain or loss). When you receive crypto as payment for goods and services, you acquired ordinary income in the amount equal to the market value of the crypto at the time of the transaction. In short, keep good records, you will need them.

What are some top strategies to minimize capital gains tax from cryptocurrency investing? As with any other investment, a little bit of planning can help you minimize your tax bill at the end of the year.

  1. HODL. The capital gains tax rate is different for short-term and long-term gains. Purchasing and selling crypto within a 365 day period is considered the short term, and any gains during that period are taxed like ordinary income (i.e. wages). Short-term crypto income will be taxed between 10% and 37%, depending on your tax bracket. On the other hand, selling crypto more than a year after buying it lets you take advantage of the lower long-term capital gains rate. Depending on your income level, long-term capital gains are taxed at either 0%, 15%, or 20%, with most people falling into the middle 15% bracket. For example, if you are paying a 22% rate on ordinary income, but are in the 15% bracket for long-term gains, you will end up with significant savings on your tax bill.
  2. Offset. Of course, not everyone buys crypto for long term investing. If you are trying to time the market and profit from crypto’s volatility, holding to gain favorable capital gains treatment may not be a feasible strategy. Tax law generally allows offsetting capital gains with losses, but the strategy does have limitations. Losses must first be used to offset gains of the same kind – for instance, short-term losses must be used to offset short-term gains, and only if you have excess short-term losses can you shift them over to reduce your long-term capital gains. If you still have remaining losses, you can take an ordinary income deduction of up to $3,000 for the tax year and retain the balance to offset next year’s gains and income.
  3. Decrease Taxable Income. Like with other “property,” you can time your sales to your specific income situation. You may want to sell appreciated crypto when you have less income than you anticipate in the future. Or, you may accelerate 401k/IRA contributions to take advantage of the up-front tax break. Health Savings Account contributions are another taxable income reduction alternative, especially if you are anticipating significant health care expenditures in the near future. For businesses, business expenses can be used to reduce taxable income, but be sure that the expense is both “ordinary” and “necessary.” For example, renting a building and paying electricity costs for your Bitcoin farm are probably ordinary and necessary expenses. Also, be careful to properly categorize any business start-up costs, assets, and improvements, which are treated as capital expenses (and therefore are different than your ordinary business expenses).
  4. Set up a self-directed IRA. Self-directed IRAs or SDIRAs are little-known but powerful investment tools for the sophisticated investor. They allow you to take full control of your retirement investments and direct the funds into non-traditional assets. Commonly used for holding real estate, private company stock, and precious metals, SDIRAs can certainly be used to buy and hold crypto. Most bank-managed retirement plans can be converted to the self-directed kind, but there are additional fees and special rules about what your SDIRA can and cannot do to retain the tax-favored treatment by the IRS. In essence, the SDIRA can be used to convert all or part of your retirement portfolio into an investment “checkbook” that you can then use to purchase and hold assets like crypto for the benefit of your retirement.
  5. Move, gift, donate, or leave it to your heirs. Depending on your situation, there are other options that may be used to optimize your tax situation. If you are in a state that imposes its own income tax, you may want to consider moving to a no income tax jurisdiction. Or potentially incorporating and locating your Bitcoin mining company there. Likewise, depending on your future goals, retirement situation, and estate planning, it may be advantageous to shift some of your crypto holdings (especially those where you are looking at a significant gain) towards those objectives. For example, if you leave your crypto portfolio as part of your estate, heirs would receive a “step up” in basis and receive the crypto at the fair market value at the time of death. This significantly reduces their tax bill and something to consider if a crypto portfolio is part of your estate planning.

There are other strategies that may be available based on your particular situation. Remember to keep good records, plan ahead, and get a professional to answer all your crypto tax questions.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Categories
business law internet law

Ask the Crypto Tax Lawyer: What Are the Tax Implications of Cryptocurrency and NFT Investing?

Important: The information in this article applies to individual investors and LLCs that are taxed as pass-through entities. The rules are different for corporations and LLCs electing to be taxed as a corporation and are not addressed here. This article is for informational and promotional purposes only and, as always, you should consult with a professional about your specific tax situation before taking any action.

2021 is the year of cryptocurrency. Bitcoin and its kin have attracted many institutional investors, smaller individual portfolios, and even some sophisticated self-directed retirement accounts. The accessibility, decentralization, and unlimited upside certainly make cryptocurrency (or crypto) an attractive investment. Or simply a fun way to try to make some extra fun money. Or lose it – the crypto market is extremely volatile and quickly reacts to government action (i.e. China’s ban) and Elon Musk’s tweets or SNL appearances.

Government regulators are watching the crypto markets. The Securities and Exchange Commission (“SEC”) has already applied securities laws to police initial coin offerings and to prosecute Ponzi schemes posing as crypto investments. As early as 2014, the IRS issued guidance (supplemented by a more recent FAQ) classifying cryptocurrency as property for tax purposes. More recently, the Department of Treasury and the IRS have zeroed in on cryptocurrency as a tax revenue source ripe for enforcement. As part of its tax reform plan, the Biden administration announced mandatory reporting of any crypto transaction of $10,000 or more starting in 2023. On May 20, 2021, the Treasury also released a report detailing the plan to close the so-called tax gap, which is the difference between taxed owed and taxes actually paid. In 2019, the gap was $600 million or 15% of all taxes, and is projected to grow to $7 billion in 10 years if left unaddressed. The biggest contributor is unreported income and Treasury and the IRS will be looking very closely at anyone who is trading cryptocurrency in the next few years for any signs of unreported or underreported taxable income.

Why are there taxes on trading crypto and how is crypto even taxed? Despite its name, cryptocurrency is not really currency for tax purposes. It is taxed like property and is subject to capital gains tax. When you purchase crypto with fiat currency (i.e. U.S. Dollars) you do not pay tax on the transaction. Note: States do not consider crypto purchases subject to sales tax – yet. But when you sell crypto, you are taxed on the gain (if any) just like you would be if you sold a stock or investment real estate. The tax rate depends on the length of time you held the asset and other factors related to your income status. Importantly, when you exchange one cryptocurrency for another (for example, you trade Bitcoin for Ethereum) the exchange is taxable. The IRS considers an exchange to be a sale of one asset for cash – income – regardless of what you do with the proceeds. Accordingly, it is critical to keep accurate and clear records of every transaction involving cryptocurrency, regardless of gain or loss. Interestingly, while the IRS considers cryptocurrency “property,” it does not consider it “securities” and therefore investors can take advantage of certain tax benefits. Specifically, crypto investors can do something called “loss harvesting” to offset taxable income from other sources.

How does the IRS verify income from crypto trading? In 2020, the IRS asked taxpayers about their participation in any cryptocurrency transactions as part of their 1040 filing. In large part, the tax system is based on self-reporting, but with third party verification checks. Bigger exchanges like Coinbase report your transaction history to the IRS and you should have received a copy of the 1099-MISC for tax year 2020. The IRS will then flag any returns that do not match the information received from the exchange and what the taxpayer puts on their return. Off-brand or off-shore exchanges may not report to the IRS, but you still have to report those transactions yourself and pay tax on any gains. As mentioned above, the Biden administration is cracking down on underreporting of taxable crypto income. This means expect to see significant and highly-publicized enforcement actions, including penalties, interest, and even jail time for tax evaders. If you do use an off-shore crypto exchange, you should also be aware of your tax obligations in the host country. The United States has tax treaties with many (but not all) countries – for example, while there is a treaty with mainland China, the treaty does not apply to Hong Kong and there is no separate treaty with Hong Kong. International tax law will also come into play if buy and sell crypto abroad or exchange it for goods or services in other countries.

What about NFTs? Non-fungible tokens or NFTs are unique digital-only objects or unique digital versions of real-world objects. This is basically computer code. Mostly associated with collectibles and art, NFTs use blockchain technology like cryptocurrency but can represent almost anything, including virtual real estate and personalized avatars. The IRS has not issued definitive guidance on how NFTs will be taxed, but most commentators agree that they will probably be considered property like cryptocurrency and be subject to capital gains tax. If you buy an NFT for U.S. Dollars, you do not pay tax on that transaction. If you sell an NFT for a profit, you just incurred capital gains tax liability, even if you are exchanging an NFT for another NFT or trading it for cryptocurrency. If you are buying an NFT with cryptocurrency, the purchase will also be subject to capital gains tax, as the IRS treats the transaction as a sale of an asset (cryptocurrency), income, and then use of that income to purchase the NFT. Currently, there are no tax exemptions or safe-harbor periods that allow traders avoid capital gains tax on exchange type transactions.

An additional question with NFTs is whether the tax rate will change based on what the NFTs represents. Is it a collectible piece of art? Then there is a special collectibles tax rate. Is it real estate? Something else? There are a lot of unanswered questions about NFT taxes at this time. But like with cryptocurrency trading, make sure to keep meticulous records of all transactions, including any gains or losses on sales.

A final item of note – estimated quarterly tax payments. The IRS (and state tax authorities) require the payment of estimated quarterly taxes from self-employed individuals or independent contractors. If you buy and sell crypto (and NFTs) make sure you are reporting and paying expected capital gains tax before the due date for payments that apply to the quarter of the sale. If you wait until the end of the year to pay taxes, you may be subject to penalties and interest for failing to pay quarterly. Additionally, you may have to liquidate other investments to pay taxes, instead of simply setting aside the capital gains estimate at the time of the original sale.

In short, if you are investing and trading crypto or NFTs, keep good records. Pay attention to any new guidance issued by the IRS. Beware false or misleading information on the internet. And above all, retain a trusted advisor to answer your questions and guide you through your tax obligations in this evolving field.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Exit mobile version