Income tax, charity and estate planning strategies for digital assets

Virtual currency and other digital assets have become popular investment tools for high net worth individuals. As individuals acquire these assets, proactively considering the income tax, charitable, and estate planning consequences of these investments can help them minimize their tax burden, comply with evolving regulations and pursue their personal wealth goals.

Digital assets: Crypto, tax, and more

The digital assets ecosystem evolves so rapidly that most individuals, regardless of how knowledgeable and experienced they are, can benefit from an overview before planning.

Digital assets can be used as a form of payment, similar to paper money, in virtual communities or in exchange for actual goods and services. They can also be exchanged for fiat currency (e.g., U.S. dollars). While digital assets are their own microcosmic economy within the metaverse, online transactions have offline day-to-day implications.

One type of digital asset is cryptocurrency. Crypto, for short, is the most commonly used virtual currency issued digitally by private parties. This specific type of virtual currency utilizes cryptography to secure decentralized transactions that are digitally recorded on a distributed ledger, as the IRS defined in 2019.

Distributed ledger technology provides a secure electronic record of data without the involvement of political or financial institutions, thus achieving a decentralized form of currency that is not controlled by any specific individual or group. Instead, it is spread across several devices on a peer-to-peer network.

Blockchain is one type of distributed ledger. Distributed ledger technology shares transactions publicly, transparently, and immutably across a peer-to-peer network. This helps to reduce fraudulent transactions, as there is no single point of weakness, and the block is validated through a network community consensus mechanism.

While cryptocurrency can function like currency in certain transactions, for tax purposes it is not currency at all. Under the latest guidance provided by the IRS as of June 1, 2022, discussed in greater detail below, it is considered property.

When a U.S. taxpayer uses cryptocurrency to buy goods or services, gain or loss is recognized because, according to the IRS, cryptocurrency itself is a capital asset.

While there are thousands of different cryptocurrencies available, they all generally fall into the category of either coins or tokens.

Coins operate on their own blockchain and are created as a form of virtual currency. Coins are the most widely known form of cryptocurrency, with bitcoin being the first cryptocurrency coin. Since its creation in 2009, thousands of other coins have been developed (e.g., ethereum, litecoin, binance coin, etc), which are simply alternative cryptocurrencies.

While coins are similar to currency, tokens are similar to collectibles. Tokens represent a programmable tradeable asset or utility that operates on an existing blockchain. There are many types of tokens; the two most common are utility tokens and security tokens.

Non-fungible tokens (NFTs) are unique tokens that exist on a blockchain and are designed to hold special value, usually in a digital asset, such as works of art, photographs, or musical pieces. NFTs can also hold physical assets, such as a deed, event tickets, or more. In 2021, the popularity of NFTs exploded in crypto communities, allowing digital creators to monetize their work on virtual platforms.

An NFT is not tangible property even when it holds physical property. It is a capital asset creating an entry on the blockchain. It is similar to buying an investment that can later be sold for a capital gain or loss. The NFT has value due to the fact it is unique, like how a highly graded rare baseball card is worth more than a very common one.

Individual income tax planning for digital assets

For years, digital asset transactions did not have the same reporting standards as most other financial transactions. However, as of Jan. 1, 2022, Form 1099-K is required to be issued to a taxpayer transacting more than $600 in payments for any number of transactions of cryptocurrency. It is important to note that even if a taxpayer is not being issued reports of their transactions, it is their responsibility to keep records and properly report income.

Taxpayers are now required to answer on their individual federal income tax return whether they have engaged in any transaction involving virtual currency. This includes, but is not limited to, sales, dispositions, exchanges of currency, receipts of virtual currency for payment for goods and services, mining and staking activities, results of a hard fork or airdrop, and any other transactions that do not qualify as gifts. If there are no current transactions and the taxpayer simply holds virtual currency acquired in a prior year, the answer can be no.

When digital assets are received as the payment for services provided, the taxpayer must recognize the fair market value in U.S. dollars as ordinary income when received. These earnings should be reported to the taxpayer on a Form 1099 or Form W-2 and may be subject to self-employment tax.

Virtual currency is treated as property for federal income tax purposes. Accordingly, federal tax principles applicable to property transactions apply to virtual currency transactions.

Specifically, cryptocurrency is categorized as a capital asset for which gain or loss may be recognized upon its disposition. However, when cryptocurrency is received as payment for services or is mined, it must be reported as ordinary income.   

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