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The IRS has started sending out letters to cryptocurrency traders warning them of the tax implications of crypto. The letter, known as IRS Letter 6174-A for cryptocurrency, alerts traders that the IRS is aware they may have misreported their cryptocurrency transactions on their tax return. This comes on the heels of the announcement that the IRS plans to release further cryptocurrency tax guidelines, according to Commissioner Charles P. Rettig.
According to Rettig, the IRS is working on providing clarity for “acceptable methods for calculating cost basis, acceptable methods of cost basis assignment, and the tax treatment of forks.” This article addresses the most important things to watch out for in the new guidance and why they matter.
1. Acceptable Methods for Calculating Cost Basis
The 2014 guidance states that the fair market value for cryptocurrency is determined by converting into US dollars “at the exchange rate, in a reasonable manner that is consistently applied.” However, this leaves considerable questions, as cryptocurrency can widely vary in price and sometimes not have a correlated USD price at all.
There are several different methods for cost basis calculation with other forms of property like trading stocks. The initial guidance does not specifically declare whether or not accounting methods like first-in, first-out (FIFO), average cost basis (ACB) or last-in, first-out (LIFO) would be acceptable for cryptocurrencies.
This gray area has left cryptocurrency investors questioning whether or not their chosen cost basis calculation method could be challenged by the IRS. Software and crypto tax calculators specifically built for crypto taxes often offer users multiple cost basis calculation options, and investors today are using a variety of methods.
Clarification around cost basis calculation is important as different methods can lead to different sizes of gains and losses. For example, in an environment of increasing cryptocurrency prices as we saw with Bitcoin in 2019, the LIFO calculation method will lead to a smaller net gain. In this case, your coins acquired at a higher cost basis will be sold off first. In turn, this will lead to less money owed on your tax bill.
However, we still don’t know whether or not LIFO is an allowable method. Clarification by the IRS around acceptable methods will be important to watch for in the coming guidance.
2. Dealing With Forks, Airdrops and Staking Rewards
In addition to questions surrounding appropriate cost basis calculation methods, there is a list of other events that need clarification for tax purposes, including crypto received from forks, airdrops and staking rewards.
Each of these types of events results in a user receiving an amount of cryptocurrency because he or she already holds another. For example, anyone who held Bitcoin on August 1, 2017, can claim a like amount of Bitcoin Cash, which was born that day. They can also claim the other currencies that subsequently split off from the main chain. This is an example of crypto received from a fork.
This issue gets more complicated when the holder has no say in whether or not they receive or do not receive crypto from a fork or airdrop event. For example, if a taxpayer holds their cryptocurrency with a custodial exchange like Coinbase, any actions that the exchange takes regarding airdropped or forked tokens should not affect the taxpayer unless such actions were undertaken at the direction of the taxpayer.
Things to watch out for as further guidance is released on forks, airdrops and hopefully staking revolve around whether or not these events should be treated as ordinary income at the time of receiving. Clarity is also needed regarding how to determine the fair market value for these cryptocurrencies.
3. Foreign Reporting Requirements
Another hot area of debate among tax professionals within the cryptocurrency community is whether or not holders of cryptocurrencies on foreign exchanges like Binance are subject to foreign reporting requirements via a Report of Foreign Bank and Financial Accounts (FBAR) and the Foreign Account Tax Compliance Act (FATCA).
These reporting requirements exist within the US for holders of foreign financial accounts but differ for other places like Australia for cryptocurrency. For example, if you have an account in Switzerland with financial assets over $10,000, you would need to file an FBAR. If the account has more than $50,000 at any time, FATCA requirements also apply and would need to be reported for taxes on cryptocurrency.
It is not explicitly clear whether or not cryptocurrency held on foreign-based exchanges fall into this category. However, the conservative approach for individuals meeting the FBAR/FATCA requirements is to file these documents as penalties for non-reporting can be significant.
Many cryptocurrency tax software can automatically build and export these forms on your behalf.
It is not clear whether or not the IRS will provide clarification for foreign reporting requirements within the new guidance, as Rettig did not state this as one of the areas of clarification. Either way, it is an important item to look out for when the new guidance is released.
It has been five years since the IRS has spoken on cryptocurrencies. Because the industry is incredibly dynamic and constantly evolving, it can be hard for policy to keep pace. This new guidance that is set to come within the next 30 days will hopefully provide clarity that will make cryptocurrency tax compliance much easier for the average US investor.