The IRS on Tuesday said it is adjusting many of its rules to account for the impact of inflation, ranging from individual income tax brackets for 2023 to the standard deduction.
The higher limits are aimed at avoiding “bracket creep” due to inflation, which can push workers who received annual cost-of-living pay increases into higher tax brackets even though their standard of living hasn’t changed.
The IRS makes such adjustments annually, but this year’s hot inflation means that many of the changes are more significant than in a typical year. Americans are struggling with stubbornly high inflation, which is eating into their purchasing power as average wage gains lag the sharp rise in prices. The higher provision thresholds could provide relief to some taxpayers who fall into lower tax brackets as a result.
Here are the changes announced by the IRS on Tuesday, with the inflation-adjusted provisions taking effect for the 2023 tax year. Taxpayers will file their 2023 tax returns in early 2024.
Standard deduction
The standard deduction is used by people who don’t itemize their taxes, and it reduces the amount of income you must pay taxes on.
For married couples filing jointly, the standard deduction will rise to $27,700, up from $25,900 in the current tax year. That’s an increase of $1,800, or a 7% bump.
For single taxpayers and married individuals filing separately, the standard deduction will rise to $13,850 in 2023 from $12,950 currently. That’s an increase of about 6.9%.
Heads of households will see their standard deduction in 2023 jump to $20,800 from $19,400 this year. That’s an increase of 7.2%.
Tax brackets
The IRS is boosting tax brackets by about 7% for each type of tax filer, such as those filing separately or as married couples. The top marginal rate, or the highest tax rate based on income, remains 37% for individual single taxpayers with incomes above $578,125 or for married couples with income higher than $693,750.
The lowest rate remains 10%, which will impact individuals with incomes of $11,000 or less and married couples earning $22,000 or less. Below are charts with the new tax brackets.
Flexible spending accounts
Flexible spending accounts allow workers to put money, up to the limit allowed by the IRS, in an account that can be used to pay for medical expenses. Because the funds are taken from their accounts on a pre-tax basis, it offers tax savings for many workers.
The new IRS limit for FSA contributions for 2023 is $3,050, an increase of about 7% from the current tax year’s threshold of $2,850.
Because employees set their FSA limits in the fall, ahead of the new calendar year, people will be using this new IRS threshold to decide on their contributions within the next few weeks.
Earned Income Tax Credit
The maximum amount for households who claim the Earned Income Tax Credit will be $7,430 for those who have at least three children, compared with $6,935 in the current tax year, the IRS said.
Bigger gift exclusion
People can also give up to $17,000 in gifts in 2023 without paying taxes on the money, up from $16,000 in the current year.
Estate tax limit
The estates of wealthy Americans will also get a bigger break in 2023. The IRS will exempt up to $12.92 million from the estate tax, up from $12.06 million for people who died in 2022 — an increase of 7.1%.
If you are among the roughly 19 million people who asked the IRS for another six months to file their taxes in 2022, time is almost up.
Almost 1 in 8 taxpayers asked for an extension to file their taxes this year, according to data from the IRS, which expects a total of about 160 million tax returns to be filed in 2022. While most Americans file their returns before the traditional April 15 deadline, people who needed more time were able to automatically receive another six months from the tax agency in order to get their files in order.
This year, the tax extension deadline for filing your 2021 return is October 17, rather than the typical date of October 15, because the 15th falls on a Saturday. Yet while that gives taxpayers a little more breathing room, experts have recommended filing as soon as possible in order to avoid last-minute pitfalls. They also recommend sending your return electronically, since the IRS has struggled mightily with processing paper returns during the pandemic.
“Using the electronic filing options can make people’s lives easier than mailing in paper tax returns,” said Eric Bronnenkant, head of tax at Betterment, told CBS MoneyWatch.
Typically, about 1 in 10 taxpayers asks for an extension, but this year may have seen a jump in requests for extra time because of the ongoing pandemic and the complexity of a tax year that included the enhanced Child Tax Credit and other tax changes.
Tax extension due date
If you filled out a Form 4868 before this year’s April tax deadline, you received an automatic six-month extension to file your taxes. As mentioned above, the extended deadline this year is October 17.
However, if you underpaid your taxes and owe money to the IRS, those payments were actually due in April. (Typically, the tax filing deadline is April 15, but in 2022 taxpayers had until April 18 to file and settle up with the IRS because the 15th fell on Emancipation Day, which is observed as a holiday in Washington, D.C.)
In other words, receiving an extension to file your taxes doesn’t give you an extension to pay the IRS.
What if I owe the IRS?
If you didn’t know you had to pay the IRS by April 18, you will likely face a “failure to pay” penalty. The same will occur if you paid the IRS in April but didn’t estimate correctly and still owe more.
The IRS says the penalty for these situations is 0.5% of the unpaid taxes for each month or part of a month the tax remains unpaid. The penalty is capped at 25% of your unpaid taxes.
Take a taxpayer who failed to pay $1,000 in taxes that they owed by the April 18 deadline. In this case, the taxpayer will face $30 in penalties for the non-payment — $5, or 0.5% of the $1,000, per month during the six months between April 18 and the October 17 extended filing deadline.
But the IRS also charges interest on penalties — and the tax agency just raised that rate to 6% on October 1 from 5% previously.
Can I still contribute to my retirement fund?
That depends whether you have a SEP IRA account, which stands for a “simplified employee pension” (or SEP) individual retirement account.
These are typically used by self-employed individuals, but are also common among small business owners. Under IRS rules, people with SEP IRA accounts can contribute to their accounts until the due date for filing their federal income tax return for the year, which means people who asked for an extension have until October 17 to sock away some money.
That can help self-employed workers or small business employees both save money and lower their taxable income for the 2021 tax year. However, the deadlines for contributing to IRA and 401(k) accounts have passed for people filing their 2021 tax returns via an extension.
What if I don’t file by October 17?
People who fail to file their return by the extended tax deadline will face harsher penalties. The IRS charges 5% of the unpaid taxes for each month that a tax return is late — or 10 times more than the underpayment penalty. It caps the penalty at 25% of your unpaid taxes. The tax agency also charges interest on the penalty.
Do disaster victims get more time to file?
Yes, the IRS is giving more time to file for people who are victims of recent natural disasters:
Hurricane Ian victims who live in Florida and have a valid extension to file their tax returns by October 17 now have until February 15 to file their tax returns.
Victims of storms and flooding that started on September 15 in parts of Alaska and who had also asked for an October extension now have until February 15 to file their returns.
Likewise, Hurricane Fiona victims in Puerto Rico who had a tax filing extension now have until February 15 to file their 2021 returns.
RESTON, Va., September 12, 2022 (Newswire.com)
– Brillient Corporation announced today that the Internal Revenue Service (IRS)Enterprise Digitalization and Case Management Office (EDCMO) has awarded them a phase 1 contract for its Pilot IRS Submission Processing Modernization (SPM) initiative.
Brillient will provide the IRS with digital transformation and solutions engineering expertise, including processing automation and artificial intelligence (AI)-enabled digitalization of incoming mail envelopes and contents, including remittances. We are privileged to continue our support for the IRS, which began 12 years ago with one of our first government contracts.
“We are excited to offer the IRS a digital mailroom solution by combining our proven digitalization capabilities with industry leading mail processing technology,” said Ed Burrows, Vice President of Intelligent Solutions.
About Brillient
Brillient is an award-winning Full Spectrum Digital Transformation company enabling clients to transform through the continuum of analog, to digital, to analytics leading to insight-driven decision making and mission execution. We help clients achieve better efficiencies and lower costs in their digital government and IT modernization initiatives enabling friction-free interaction with the American people and businesses.
The IRS has recently announced a number of changes related to identification requirements impacting Qualified Intermediaries (QIs). This blog is the first of a two-part series and describes how the current design of the Secure Access Account (SAA), and in particular the request to provide a US Tax identification number to validate the QI’s Responsible Officials identity, would impair the QIs’ capabilities to comply with their electronic reporting obligations through FIRE. The second part of this series, covering QI’s new due diligence challenges linked to their non-US account holders’ US Tax identification number requirement for 1446(a) and 1446(f) purposes, will follow in a separate blog.
On 26 July 2021 the IRS announced (IRS release available here) it is substantially transforming the existing application procedure for Filing Information Returns Electronically (FIRE) transitioning from Form 4419 to the Information Returns (IR) Application system to obtain the Transmitter Control Code (TCC) required to file electronically via FIRE.
This transformation is particularly relevant for QIs since they have no other option than filing Forms 1042-S (and sometimes Forms 1099) electronically via FIRE.
Currently, the planned changes are not fit for most QIs. Specifically, the system preliminary requires QI’s Responsible Officials to validate their identify through a SAA, unfortunately designed for individuals with US tax filing requirements.
Luckily this transition is happening progressively and thus most QIs are not yet impacted provided that prior to August 2022 they ensure that the identifying information (legal business name, mailing address, and/or contact information) associated with their active TCC received before 26 September 2021 is current and correct to log into the FIRE System.
We recommend that QIs immediately validate that the information the IRS has on file is current and correct. If changes are needed, QIs should use paper Form 4419 (Rev. 9-2021) to update this information given that as of 2 August 2022, the IRS will discontinue the paper form process to transition to the IR TCC application system to make such changes. As of this date the complex issues of gaining access to the new system will be a reality for QIs with the risk of being shut out of FIRE if their legal business name is incorrect (e.g., spelling, abbreviations, special characters and spacing do not match the IRS records).
New FIRE users
As of 26 September 2021, new FIRE users can no longer make use of paper and fill-in versions of Form 4419 to request an original TCC, the five-digit number required to file electronic returns through FIRE. Instead, they need to use the new online IR Application for TCC. Additionally, in order to access the IR Application for TCC, new FIRE users are firstly required to verify their identity by creating a Secure Access Account (SAA) to improve security features and thus protect from fraudulent access.
Since at least two Responsible Officials need to be listed on the IR Application for TCC, both persons need to create their own respective SAA.
The IR Application for TCC currently foresees that users need to provide the following information amongst other to create an SAA:
The user’s Social Security number (SSN) or Individual Tax Identification Number (ITIN);
The user’s tax filing status and mailing address from the most recently filed tax return;
A financial account number linked to the user from one of these account (last eight digits of Visa, Mastercard or Discover Credit Card, Student loan, Mortgage or home equity loan, Home equity line of credit, or Auto loan); and
A US-based cell phone in the name of the user (for faster registration) or a mailing address where the user can receive an activation code by mail.
Existing FIRE users
Existing FIRE users (i.e., those who submitted their TCC Application prior to 26 September 2021) were originally scheduled to transition to the IR Application for TCC in Fall 2022.
However, on 16 June 2022, the IRS granted existing FIRE users more time to transition to the new system (IRS release available here). Those existing TCCs will remain active until 1 August 2023. After that date, any FIRE TCC that does not have a completed IR Application for TCC will be dropped and will no longer be available for e-filing. Accordingly, existing FIRE users will need to validate their identity via the SAA, log in to IR application for TCC and complete the online application between September 2022 and 1 August 2023.
Existing FIRE users, not yet transitioning to the IR Application, are currently allowed to use paper Form 4419 (Rev. 9-2021) to revise identifying information (legal business name, mailing address, and/or contact information) associated with an active TCC received before 26 September 2021.
However, paper Form 4419 will be discontinued as of 2 August (IRS release available here) to transition to the IR Application for TCC also for purpose of revising existing TCC information. Therefore, prior to August 2022, existing FIRE users will need to ensure that the information on their application (submitted via Form 4419) contains the current contact’s name, current email address and current telephone number and verify that the company’s current legal business name is correct (spelling, abbreviations, special characters and spacing) to match the IRS records. If any information needs to be updated, the changes through Form 4419 need to be received by the IRS by 1 August 2022. Notably, as certain QIs have already started experiencing, an incorrect legal business name will trigger the inability to file information returns electronically via FIRE.
QIs may risk being unable to create an SAA and consequently left out of FIRE
As mentioned above, the setup of an SAA, currently foreseen by the IR Application for TCC, requires either an SSN or an ITIN.
At its most basic level, an SSN is used by US citizens and authorized noncitizen residents (i.e., noncitizens authorized to work in the US).
An ITIN is a tax processing number issued by the IRS to individuals who are required to have a US taxpayer identification number but who do not have and are not eligible to obtain an SSN from the Social Security Administration. In general individuals must have a filing requirement and file a valid federal income tax return to receive an ITIN unless they meet an exception. However, a specific exception applies for a non-US representative of a foreign corporation who needs to obtain an ITIN for the purpose of meeting e-filing requirements.
Since employees of QIs generally do not have a connection to the United States, other than working at a bank that holds US securities, they cannot apply for an SSN. However, based on the above-mentioned exception, they can apply for an ITIN.
Accordingly, some QIs have already asked certain of their non-US employees to apply for an ITIN via Form W-7 to create an SAA to be able to obtain a TCC via the IR Application to continue to use FIRE.
Unfortunately, this appears to not yet be sufficient to ensure the creation of an SAA. Although the instructions for Form W-7 allow to apply for an ITIN for e-filing purposes absent a US filing requirement, the SAA presumes a US filing requirement and consequently asks for the user’s tax filing status. This misalignment results in an insurmountable obstacle for most QI’s employees unable to create their SAA. As a result, QIs cannot obtain the required new TCC.
What are the alternatives?
The IRS, through its Frequently Asked Questions about the IR Application for TCC originally envisaged two options:
Enlist a third party to file on their behalf; or
Purchase a software package to support their electronic filing.
An IRS representative, speaking at the last Kaplan Financial Education tax conference in June 2022, indicated that the FAQ was revised to no longer refer to option 2 above, leaving as sole alternative option 1.
Although option 1 is technically possible, QIs face many issues to put in place the necessary infrastructure to enable it to outsource this activity to a 3rd party in light of client confidentiality (e.g., the case of Form 1099 or nominative Form 1042-S reporting).
At the same conference, the IRS indicated it is aware of the implementation issues that non-US filers are facing and that “this is actively being worked and considered”. The IRS representative encouraged stakeholders to bring forward alternatives and provide comments to notify the Service of concrete examples of the challenges that non-US filers are facing.
Deloitte’s view
Although SAA is today a limited problem for QIs that are existing FIRE users, given they still have more than a year to transition to the new IR TCC application, they immediately need to check that the information associated with their current TCC is correct. If this is not the case, QIs need to make sure that the IRS receives the corrected legal business name via Form 4419 by 1 August 2022 at the latest to avoid being shut out of the FIRE system (after this date, revising the information associated with a TCC will only be possible through the IR TCC application system with the current SAA issues described above).
QIs that are existing FIRE users having submitted their TCC Application prior to 26 September 2021, will meanwhile also face the aforementioned SAA issues in case they need an additional TCC or to add a new Form Type. This is because in both circumstances the completion of the IR Application for TCC is required.
Although Deloitte recognizes the need to strengthen validation controls to protect against unauthorized filing and input of fraudulent information returns, it is clear that SAA, as currently designed, does not work for QIs.
QI’s Responsible Officials don’t generally have US tax filing requirements, and as such are unable to populate the user’s tax filing status necessary to go through SAA.
At the same time, since non-US applicants will generally not have a US-based mobile phone, requesting them to provide, at SAA set-up, an international postal mail to receive a one-time code that is only valid for 30 days appears an inappropriate way of communication; experience shows that IRS mail is sometimes received by QIs after 30-days of issuance.
It is unclear whether it is feasible for non-US applicants to provide the required information pertaining to a financial account or whether such account must be one maintained in the US linked to their name.
Therefore, we encourage the IRS to make the SAA process accessible to QIs and more broadly to non-US filers. For this purpose, we would suggest keeping the ITIN requirement consistent with the instructions for Form W-7, while eliminating the need to provide the user’s tax filing status. Moreover, we propose to allow non-US applicants to access the SAA without requesting any financial information and giving the option to provide a non-US phone number or a non-US e-mail address to receive the one-time code through the SAA process.
There are clearly several obstacles to overcome in order for QIs to have the required access to fulfil their reporting obligations as of August 2023. However, it is quite clear that obtaining an ITIN (which usually takes a few months) will be most likely one of the steps of the transition process. Deloitte, as Certifying Acceptance Agent (CAA), can assist and simplify the ITIN application procedure in the following ways:
Support with the completion of Form W-7
Review and authenticate the applicant’s passport to verify his/her identity and foreign status
Submit to the IRS the completed Form W-7 together with a copy of the applicant’s passport; and
Brandi heads Deloitte’s Financial Services Tax team in Switzerland and Liechtenstein. She has extensive expertise in advising the Swiss financial services industry on the implementation of US and international transparency regimes (including QI, FATCA, Section 871(m), CRS, MDR and DAC6). Brandi also leads the Financial Services Tax team’s efforts relating to innovative technology solutions. Brandi is a US Certified Public Accountant and has 20 years of experience with Deloitte and has worked in London, San Diego and Zurich.
Karim leads the Tax Transparency team in the Suisse Romande and Ticino markets within the Financial Services Tax practice and is responsible for services relating to QI, FATCA, CRS, 871(m) and DAC6. He is a technical advisor and subject matter expert to financial institutions in the banking, trust, and insurance sectors. Prior to joining Deloitte, Karim worked for eight years in support teams of Swiss banks, in particular in areas relating to operations, project and change management as well as operational taxes.
Elena Bonsembiante – Manager Financial Services Tax
Elena is a QI, FATCA and CRS specialist and an Italian certified public accountant. She is leading as Manager several QI, FATCA and CRS projects for middle sized banks in the French and Italian speaking areas. Prior to joining Deloitte Switzerland, she worked for Deloitte Italy and other Italian Tax Firms.
President Joe Biden speaks about the March jobs report in the State Dining Room of the White House, Friday, April 1, 2022, in Washington. (AP Photo/Patrick Semansky)
ASSOCIATED PRESS
What Happened
On March 28th, 2022, the Department of Treasury issued the 2023 Fiscal Year Revenue Proposal (The Green book) outlining a number of proposed tax policies designed to increase revenues, improve tax administration, and make the tax system more equitable and efficient. The proposal had several key policies that will have a direct impact on crypto taxpayers if adapted as proposed.
Key Concepts
Tax Policy Changes Targeted Towards High-income Taxpayers
The proposal has three major tax policy changes focused on high income earner in the US. First, the treasury wants the highest marginal income tax rate to increase from 37% to 39.6% effective December 31, 2022. This increased marginal rate would apply to taxable income over $450,00 for married filers and $400,000 for individual filers. If your total taxable income is above these thresholds, your short-term cryptocurrency gains (coins & NFTs sold after holding them for less than 12 months) and other types of crypto income such as staking, mining & interest would be subject to this higher rate.
Second, the proposal is planning to subject long-term capital gains (which are generally subject to a lower tax rate than ordinary income tax rate) to a higher tax rate for taxpayers with over 1 million of taxable income. For example, if your overall taxable income is over 1 million, long-term gains in excess of 1 million would be subject to a much higher ordinary income tax rate vs the maximum 20% rate under the current law. Furthermore, the proposal aims to make transfers of appreciated property as gift and at death as taxable events for wealthy individuals.
Third and arguably the most aggressive tax proposal included in the document is the 20% minimum tax on “Total income” for taxpayer’s worth over 100 million. Total income includes regular taxable income such as wages and investment income and surprisingly unrealized capital gains on assets you own.
Specific Policy Changes For Digital Assets
The proposal includes four digital assets specific tax policy changes. Let’s first go through the three policies that have a direct impact on taxpayers.
The first proposal talks about cryptocurrency lending activity which has expanded rapidly over the past several years. The treasury aims to make cryptocurrency-based loans tax-free similar to loans based on stocks & securities, as a long as certain criteria is met. This is good news for taxpayers who are involved in lending activity.
Certain specified financial assets (foreign bank accounts, brokerages, etc.) held by US individuals in foreign countries have been subject to IRS reporting for many years. To comply with the rules, US taxpayers with foreign accounts in excess of $50,000 are required to file a Form 8938 (Statement of Specified Foreign Financial Assets) disclosing various information about those assets. Whether digital assets held in overseas exchanges are subject to Form 8938 reporting has been a grey area for several years. The treasury proposal finally adds clarity to this lingering question and want to subject digitals assets to Form 8939 reporting.
The next digital asset-specific tax policy change involves day traders of cryptocurrency. Section 475(f) tax election has been a taxpayer-friendly election active day traders of stocks have been enjoying for many years. When this election is properly made, day traders can mark-to-market their positions at year end and treat gains and losses as ordinary income. This allows them to deduct unlimited amounts of losses and override the $3,000 annual cap on capital loss deduction other taxpayers are subject to. If we strictly follow the current law, this favorable tax election is only applicable to stocks and commodity traders. The treasury has clearly identified the growth of crypto markets and proposed to extend this favorable election to active digital asset traders. This is another positive policy change.
The final proposal related to cryptocurrency is aimed at US cryptocurrency exchanges. To effectively combat offshore tax evasion, the US tax regulators heavily rely on information shared by foreign financial institutions and governments on financial accounts owned by US individuals in foreign countries. The success of this system heavily depends on reciprocity. In simple terms, the US must share information about US financial accounts owned by foreign individuals to those respective countries; Foreign countries must report to the US when US individuals hold financial accounts in foreign countries. This continuous information sharing enables regulators to catch bad actors using offshore strategies to evade taxes.
To strengthen reciprocity when it comes to crypto-related information sharing, the treasury would require US digital asset exchanges to report account balance for all financial accounts maintained at a US office held by a foreign person to the IRS.
“This would allow the United States to share such information on an automatic basis with appropriate partner jurisdictions, in order to reciprocally receive information on U.S. taxpayers”
All aforementioned proposals would be effective after December 31, 2022, except the rule that mandates US exchanges to report foreign account holder information, which is planned to be effective after December 31, 2023. According to treasury estimates, these digital assets specific rules will raise approximately 11 billion in tax revenue between 2023 and 2032.
Next Steps
Monitor how the proposed rules are processed through the legislative process in the coming months.
MIAMI, FLORIDA – JUNE 04: MicroStrategy CEO Michael Saylor speaks at the Bitcoin 2021 Convention (Photo by Joe Raedle/Getty Images)
Getty Images
What Happened
MicroStrategy has been purchasing bitcoin since 2020 as a part of its capital allocation strategy. The company holds over 120,000 BTC as of the end of December 2021. As a U.S. public company, MicroStrategy is required to report earnings and transactions related to bitcoin under Generally Accepted Accounting Principles (GAAP) standard. However, properly accounting for these transactions in GAAP financial statements is an emerging area. The current GAAP standards that classify digital assets as intangible assets with indefinite lives (similar to goodwill and trademarks of a business), fail to capture the true financial behavior of bitcoin holdings. This treatment requires companies to report a loss when digital assets’ prices fall below the cost; however it prohibits marking up digital assets to it’s true value when prices later recover. This discrepancy can negatively impact a company’s net income, which could incorrectly translate into lower price per share.
The Financial Accounting Standards Board (FASB) is the IRS of the accounting world. The FASB is responsible for creating Generally Accepted Accounting Principles (GAAP). As of the date of posting, there are still no cryptocurrency specific GAAP rules.
In the absence of these crypto specific rules set by the FASB, in 2020, a working group formed by the American Institute of CPAs (AICPA) came up with a Digital Asset Practitioner Guide addressing how to classify cryptocurrencies in GAAP financial statements.
How Cryptocurrencies are Classified on GAAP Financials
According to the white paper issued by the AICPA, crypto assets cannot be classified as “cash or cash equivalents” on GAAP financial statements because they are not backed by a sovereign government or considered legal tender. They cannot be classified as a financial instrument or a financial asset because they are not cash (see above why) and do not represent any contractual right to receive cash or another financial instrument. Additionally, since cryptocurrencies are intangible, they do not clearly meet the definition of inventory and cannot be labeled as inventory on the balance sheet either.
After going through the process of elimination, we are left with only one category to classify cryptocurrencies under: intangible assets with indefinite life. This is how MicroStrategy currently classifies bitcoin in their financial statements.
(3) Digital Assets: The Company accounts for its digital assets as indefinite-lived intangible assets in accordance with Accounting Standards Codification (“ASC”) 350, Intangibles—Goodwill and Other. The Company’s digital assets are initially recorded at cost. Subsequently, they are measured at cost, net of any impairment losses incurred since acquisition” (10-Q, page 11)
Practical Mismatches with Intangible Asset Treatment
There are a few problems with classifying cryptocurrencies as intangible assets with indefinite life. Practically speaking, this accounting treatment does not align with the reality. Cryptocurrencies like bitcoin are liquid and work extremely similar to cash. The purpose of GAAP financial statements is to paint an accurate, unbiased picture of the underlying entity’s financial situation. By treating crypto assets as intangible assets, GAAP financials fails to communicate the high liquidity of crypto assets.
Second, once an item is classified as an indefinite life intangible asset, it should be tested for impairment. This means, if the value of the crypto asset has gone down at the end of the reporting period, the business gets to write off that amount as an impairment loss (not to be confused with tax losses) on the income statement. However, if the value goes back up (which is common due to high volatility), the business does NOT get to mark up the value of the asset. This overly conservative approach often results in businesses showing poor operating results under GAAP which negative affects investor sentiment and stock price.
For example, MicroStrategy reported $65,165,000 of impairment losses for the three months ending September 30, 2021, because the market value of bitcoins went below their purchase price. Although this 65M impairment loss was not a cash outflow from the business, it was the largest operating expense which contributed to a net loss of $36,136,000.
Similarly, during the three months ending September 30, 2021, Tesla reported 51M of impairment loss. Square reported 6M of bitcoin impairment loss in the same period.
MicroStrategy consolidated statement of operations
MicroStrategy
To clarify the situation and show the true performance of the business to investors, MicroStrategy added a section named, “Non-GAAP Financial Measures” in their 10-Q. This section shows what would their operating income be without taking impairment and few other non-GAAP amounts (not related to digital assets) into consideration.
According to this schedule, if impairment loss was not considered (and few other items not relevant to bitcoin), the company would have a net income of $18,566,000.
Reconciliation of non-GAAP net income schedule
MicroStrategy
SEC Letter to MicroStrategy
The SEC objected MicroStrategy’s Reconciliation of non-GAAP net income schedule above. On December 3, 2021, it sent the company a comment letter and advised the company to remove it under the Rule 100 of Regulation G.
Reg G requires public companies to “disclose or release such non-GAAP financial measures to include, in that disclosure or release, a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure”.
Although we don’t know the specifics of the situation, it is clear that MicroStrategy’s 10-Q includes GAAP financials & a reconciliation of non-GAAP net income schedule allowing readers to compare numbers easily. The company’s goal is to clearly communicate the true operating performance of the company minus the “paper bitcoin losses” which is required to report under incompatible GAAP rules. Therefore, the specific concern the SEC has with the presentation is unclear. It is also interesting to see that the letter is only talking about the “adjustment for bitcoin impairment charges” among other items included in the Reconciliation of non-GAAP net income schedule such as share-based compensation, interest expense and income tax effects.
On a subsequent letter from MicroStrategy dated December 16, 2021, the company accepted SEC’s comments and removed the adjustment for bitcoin impairment on the reconciliation of non-GAAP net income schedule.
Finally, the rising inflation and the uncertainly of interest rates have moved the market sentiment from investing in risky companies to value stocks of profitable companies. Microstrategy may find it challenging to show a net profit under GAAP in the coming months if the price of BTC moves sideways in a bearish market or declines further creating more impairment losses. Even when BTC goes up, Microstrategy will not be able to show a profit under GAAP unless they sell it. This situation could unfairly affect the stock price of the company. If a spot BTC ETF gets approved, investors might be better off directly investing in the ETF compared to using Microstrategy as a way to get exposure to BTC.
Next Steps
Keep an eye on how SEC approaches Non-GAAP disclosures related to bitcoin for other public companies holding bitcoin.
cloud with rain of coins on blue background. minimal concept of investment, success and cryptocurrencies. 3d rendering
getty
What Happened
Airdropping is a popular method used by cryptocurrency projects to reward early adopters. For instance, we saw projects like Flare and Uniswap ($UNI token) airdrop $FLR and $UNI tokens to millions of users in 2020. So far, over 133M $UNI tokens worth over 3 billion have been claimed by the users.
Similarly, anyone who had an Ethereum Name Service (ENS) domain as of October 31, 2021, is eligible to receive free $ENS tokens. Specifically, 82,047 of the 137,689 addresses have claimed the airdrop as of November 17, 2021. The specific amount available per address depends on their level and duration of involvement with the project. Currently, $ENS is trading at approximately $50 per coin, making it a lucrative opportunity.
Key Concepts
What are Airdrops?
Airdrops are free tokens that you are eligible to receive as a result of being an early adopter of a cryptocurrency project. Some are surprises. For example, Uniswap airdropped 400 $UNI tokens to early users of the Uniswap exchange. Other airdrops are planned in advance to drive up prices and publicity. For example, Flair had been talking about a potential airdrop for $XRP holders for a while before it occurred on December 12, 2020, the snapshot date.
The redemption processes can differ as well. Sometimes, you get airdrops automatically in your wallet without any action from your end. In other cases, you have to intentionally claim the free tokens by following the instructions provided by the project. For example, if you had an ENS domain as of October 31, 2021, you can claim your free $ENS by going to https://claim.ens.domains/.
Airdrop Taxes
The IRS has not issued any direct guidance on airdrops sent to early adopters of a project. It is reasonable to think that such airdrops are unsolicited property for tax purposes because the recipient doesn’t have any prior knowledge about the airdrop. Moreover, the Rev. Rul. 2019-24 talks about airdrops that could happen pursuant to a hard fork. Although the background provided here may not be directly applicable to the $ENS airdrop (since there’s no Hard fork), the dominion & control doctrine used here is important when determining the tax consequences.
According to past unsolicited property tax rulings (Technical Advice Memorandum 8109003 and 8109004) and the details provided in the Rev. Rul. 2019-24, surprised airdrops like the $ENS token is likely taxed at the time the taxpayer gains dominion & control over the asset. In simple terms, this means at the time you claim the token and have the ability to transfer, exchange or sell the coin. The amount of ordinary income to be reported is the fair market value at the time you gain dominion and control. This amount would be subject to ordinary income taxes (10% – 37%) based on your income tax bracket.
For example, say you claimed (exercised dominion & control) one $ENS token on November 08, 2021. On this day, one ENS token was approximately worth $30 according to CoinMarketCap data.Therefore, you have to report $30 of ordinary income.
Say you later sell this $ENS for $50. Then, you would pay capital gains taxes on $20 ($50 – $30).
Note that some airdrops could automatically appear on your wallet without you taking any action. In these cases, you’d have a taxable event even If you didn’t want the airdrop. This is because the dominion and control is automatically established when the coins appear on your wallet. If the price of the coin later drops and/or you don’t want the coin, you may still be liable for the tax bill based on the price at the time you received them. Here, you can liquidate the coin at a loss to offset the income reported at receipt.
How to Plan Taxes Around the $ENS Airdrop
ENS protocol allows you to claim $ENS until May 4th, 2022. There are couple of actions you can take to reduce and defer taxes on the $ENS airdrop. First, you can wait until the prices go down before claiming the token, if you think that they will. Going with the example above, assume you claim $ENS in December 2021 when the price is $20 per coin. Here, you’d report $20 of ordinary income instead of $30. On the other hand, if the price rises, you would end up reporting more income.
Second, you can claim your $ENS between January 1st, 2022, and May 4th, 2022. By doing so, you can defer the taxable event to the 2022 tax year. If you are subject to a lower tax bracket in 2022 compared to 2021, this will reduce your taxes on the airdrop. Further, 2022 taxes are due by April 2023. This gives you ample time to observe the prices and sell when the price is at Its highest.
Either way, it is also important to set aside some money to pay the related taxes on the income reported on the airdrop. The amount to be set aside varies depending on your filing status and the tax bracket. If the airdrop is a large amount, it is recommended to talk to a tax adviser and calculate the estimated taxes on the airdrop.
Finally, you can entirely eliminate taxes by not claiming the airdrop at all. If you don’t claim the tokens by May 4th, 2022, you will potentially lose access to the airdrop. According to the ENS website, tokens not claimed by this date will be sent back to the ENS DAO treasury. If you don’t claim, you will not have any taxable event because you never gained dominion & control over the asset.
Next Steps
· Consider claiming $ENS when the market price is low.
· Consider claiming $ENS between January 1st, 2022, and May 4th, 2022, to defer tax liability to the next tax year.
· Have enough cash in hand to pay the related tax liability generated from the airdrop.
As commerce becomes increasingly global, the financial system grows and digital assets become more ingrained in our lives than ever before, governments and regulators are pushing back with even more restrictions to maintain control over the industry. Some would argue that they have gone too far, or are fighting the wrong battles. In light of the pace of innovation, especially in the cryptocurrency space, where privacy is often mandatory, these distractions are likely to keep them playing catch up and perhaps on the wrong side of history.
Key Background
In May 2021, the Treasury Department released the Biden administration’s revenue proposals for fiscal year 2022. They include a key requirement that would apply stringent reporting requirements to all business and personal accounts from financial institutions. Specifically the proposal covers, “bank, loan, and investment accounts, with the exception of accounts below a low de minimis gross flow threshold of $600 or fair market value of $600.” In other words, financial institutions will report any flows in and out of business and personal accounts of more than $600 regardless of whether they are based in fiat or cryptocurrency. Then in late October the Treasury offered an additional threshold of more than $10,000 in transfers in a given year.
All of this adds to a restrictive climate towards crypto, especially for ‘privacy coins’, a part of the industry that promotes privacy as its key value proposition. This sentiment has put them under the regulatory microscope and led several exchanges to de-list certain tokens to avoid regulatory ire.
Things are not stopping at US shores either. Internationally, in late October 2021 the global AML agency, the Financial Action Task Force (FATF) released its updated guidance for firms that handle cryptocurrency and virtual assets. The guidance increased transactional reporting requirements for virtual asset service providers (VASPs), which are defined to include a lot more companies than just centralized exchanges.
However, rather than lying down, as governments continue to encroach on financial privacy, the cryptocurrency community is pushing forward with privacy initiatives to safeguard this basic human right. The most recent example came last week when Findora, a privacy-centric blockchain developed by Discreet Labs announced a $100 million ecosystem fund to be used for research, development of new applications, infrastructure such as staking, and liquidity so these platforms and ‘privacy coins’ offer similar levels of utility to more prominent blockchains such as Bitcoin or Ethereum.
Investors are noticing. Many privacy coins have proven to be solid investments in 2021, as several have quietly outperformed bitcoin during this bull market, which bodes well for the industry moving forward.
Key Actors
Treasury Department & Internal Revenue Service (IRS)
Financial Action Task Force (FATF)
New York Department of Financial Services (NYDFS) – Jon Blattmachr (Deputy GC of INX, former Virtual Currency Chief of NYDFS)
Zcash – Zooko Wilco and Josh Swihart
Monero – Riccardo Spagni
Cake Wallet – Vik Sharma
Findora/Discreet Labs – Warren Paul Anderson
Secret Foundation – Tor Bair
Broader Context
Contrary to the popular narrative, bitcoin and other cryptocurrencies do not provide a high degree of anonymity or privacy. Bitcoin is pseudonymous, meaning transactions are linked to your wallet address rather than your name. Bitcoin’s transactional records are stored on the public blockchain in plain view; so as a result, Bitcoin is one of the more transparent ways to send money. While someone’s full name would likely not be connected directly to a Bitcoin transaction, the network can see everyone’s public address and it doesn’t take much to pair an identity to a public key. This means transaction amounts, frequency, and balances are all open for the entire public to see. Many cryptocurrency exchanges also require their users to go through their anti-money laundering/customer due diligence (AML/KYC) to define customers’ identities before using the platform. Additionally, the growing cottage industry of crypto forensic and analytic companies led by Chainalsyis, Elliptic, and CipherTrace have proven adept at attaching identities to illicit transactions. In this sense, legal tender today is much more private than bitcoin.
According to Warren Anderson, VP of Product at Discreet Labs, the team behind Findora, “[w]hen someone exchanges coins or banknotes for a good or service, that transaction is only known to the two parties involved. . .Further, if you hand a $10 bill to the woman at the local farmer’s market, she can’t look up how much you have left in your bank account.”
Privacy coins are specifically designed to add a much needed layer of privacy to the benefits and functionality of cryptocurrency. A privacy coin can keep information about its users hidden, including identity, size of cryptocurrency transactions, or the amount of cryptocurrency a person holds. Most projects have some sort of “view key” in which a user, exchange or regulator can pierce through the privacy layer and access the encrypted information.
Examples of Privacy Coins
There are a variety of privacy coins that function in different ways. A few are listed below:
Zcash — Zcash was launched in October 2016 as a fork of Bitcoin and uses zero-knowledge proofs to provide a means for nodes on the network to verify that a transaction is valid. It accomplishes this feat without giving them any information about the transaction, including sender, receiver, or transaction amount. One unique characteristic about Zcash is that it not only facilitates fully private transactions, but it also offers public transactions similar to Bitcoin or the ability to make certain aspects of a transaction public or private. Zcash’s transparent setting is its default, not shielded and exchanges can reveal information to law enforcement. This makes it arguably more friendly to regulators than other options.
Monero – Monero launched in 2014 as a Bytecoin fork, a privacy focused cryptocurrency based on CryptoNote technology and launched in July 2012. Monero relies on stealth addresses and ring signatures to hide everything from the addresses of the sender and recipient to the full transaction amount. Privacy coins that use stealth addresses create new addresses for every single cryptocurrency transaction while Ring signatures group many public keys together in a transaction so that outside observers cannot determine the exact participants. Monero also offers optionality for users to reveal their transaction but it cannot be forced by law enforcement or an exchange. Only the key holder can reveal their transactions.
Findora — Findora is a public blockchain with programmable privacy. Findora utilizes zero-knowledge proofs and multi-party computation to allow users transactional privacy with selective auditability. Whereas some privacy protocols, namely Zcash and Monero, offer simple reveal keys to allow transaction auditability, Findora takes it a step further with selective disclosure agreements by supporting a variety of other compliance proofs to allow for more enhanced auditability without compromising privacy. Findora began as a research project in 2017, but mainnet beta launched March 2021 after a fund raise in late December 2020.
Secret Network – Secret Network is said to be the first blockchain to integrate privacy by default for Ethereum smart contracts. Smart contracts are self-executing pieces of code that are managed on a blockchain like Ethereum. Secret Network improves upon traditional smart contracts by supporting encrypted information within the contract.
“Regulators inherently dislike privacy. But that’s only because when they hear privacy, they think secrecy. These concepts are not one in the same.” – Warren Anderson, VP of Product at Discreet Labs
Financial Privacy – A Historical Review
The desire and need for privacy is a generally accepted concept that started long before crypto. Most people are very familiar with the Fourth Amendment, which originally enforced the notion that “each man’s home is his castle” that is secure from unreasonable searches and seizures of property by the government. The Fourth Amendment protects against arbitrary arrests, and is the basis of the law regarding search warrants, stop-and-frisk, safety inspections, wiretaps, and other forms of surveillance.
The Fourth Amendment’s protections apply to financial privacy as well. The Right to Financial Privacy Act of 1978 protects the confidentiality of personal financial records by creating a statutory Fourth Amendment protection for bank records. Generally, the Act requires that federal government agencies provide individuals with a notice and an opportunity to object before a bank or other specified institution can disclose personal financial information to a federal government agency, often for law enforcement purposes. The Act was in response to the U.S. Supreme Court’s 1976 ruling in United States v. Miller, where the Court found that bank customers had no legal right to privacy in their financial information held by financial institutions.
The United States also understands the importance of privacy and encryption of transactions and payments on the internet. Once commerce became a large use-case for the internet, thieves made efforts to steal credit card numbers printed in clear text in the unencrypted HTTP traffic. According to Zooko Wilcox, founder of Zcash, the solution turned out to be encryption, though this was initially controversial. In the early days of the Internet, the National Security Agency (NSA) and others were concerned about the potential use of cryptography by terrorists and criminals. Today, HTTPS is a requirement for transmitting data on the internet and is mandatory for all US government agencies, including those which were initially against public access to encryption.
Privacy is fundamental to security and usability, and users deserve and expect strong privacy protections no matter where they’re active online.” – Tor Bair, Founder of Secret Foundation
Regulatory Mistrust of the Desire for Privacy
Like the days of the internet and the introduction of HTTPS, regulators are still uncomfortable with the concept of financial privacy and privacy coins. The Right to Financial Privacy Act of 1978 offers clear classes of exceptions in which certain financial records are not protected by the Act, for example as it relates to tax reporting, pursuant to other federal statutes or rules, administrative or judicial proceedings, and legitimate functions of supervisory agencies or if the subject of a suspicious activity report (see 12 U.S.C. §3403(c)). In these situations, disclosure by a financial institution is permitted, and no subpoena or warrant is required. In many ways, regulators seem to equate the desire for privacy with someone who has something to hide. This can be especially true when it comes to cryptocurrency, and was a key point of contention when the IRS submitted a John Doe summons to Coinbase in 2016 in hopes of identifying crypto tax evaders.
A primary concern of regulators is preventing money laundering and terrorist financing. Bank Secrecy Act (/BSA) Requirements require companies to implement KYC and transaction monitoring. Further, BSA rule 31 CFR 103.33(g) — often called the ”Travel Rule” — requires all financial institutions to pass on certain information to the next financial institution, in certain funds transmittals involving more than one financial institution.
Under the Travel Rule, all transmittor’s financial institutions must include and send the following in the transmittal order to the recipient financial institution:
The name of the transmitter,
The account number of the transmitter, if used,
The address of the transmitter,
The identity of the transmitter’s financial institution, The amount of the transmittal order,
The execution date of the transmittal order, and
The identity of the recipient’s financial institution;
and, if received:
The name of the recipient,
The address of the recipient,
The account number of the recipient, and Any other specific identifier of the recipient.
FATF recently released its updated guidance to include firms that handle cryptocurrency and virtual assets. Since 2018, FATF has issued a series of draft papers that sought to define VASPs and virtual assets, and also recommend how countries implement the Travel Rule for cryptocurrency transfers.
Comparison of requirements under BSA and Travel Rule
CipherTrace
More recently, FATF has tried to account for transactions to and from “unhosted wallets,” decentralized finance (DeFi), non-fungible tokens (NFTs) and decentralized autonomous organizations (DAOs).
The above requirements appear to stand in conflict with the goal of privacy coins which can shield potentially identifying information about transferors, transferees, and holders. Regulators are worried that these features can enable money laundering and terrorist financing by preventing their ability to track the movement of the coins.
Privacy coin laws vary by country, as with any other cryptocurrency. Some ban them outright, while others leave them in a legal gray area. South Korea and Japan, for example, have decided to make the use and possession of privacy coins illegal.
Josh Swihart of Zcash noted to me, “The categorization of some coins as ‘privacy coins’ is going to lead to brittle regulations with regulators trying to play privacy whack-a-mole. Policy makers should be pushing for privacy rather than fighting against it in order to protect civil liberties as well as national security.”
New York Department of Finance Services As a Microcosm Of Privacy Coin Scrutiny
Perhaps the competing priorities of privacy and regulation are no better exemplified than what is happening in New York. Privacy coins are especially limited for New York residents as a result of the New York Bitlicense. Section 200.10 states that any Bitlicensee “must obtain the superintendent’s prior written approval for any plan or proposal to introduce or offer a materially new product, service, or activity, or to make a material change to an existing product, service, or activity, involving New York or New York residents.” In New York, for many years this meant that exchanges like Coinbase and Gemini who have the Bitlicense still needed to obtain approval from New York on a coin-by-coin basis.
“At NYDFS, we had presentations that helped folks understand that there are many existing methods by which most cryptocurrencies, even BTC and ETH, can have their transactions masked. This masking can lead to transactions that make them as private as the privacy coins we’re discussing. This engagement didn’t lead to DFS’s backing down from its position on privacy coins, but the more regulators know, the more they can make rational, informed decisions about policy.” – Jon Blattmachr
As Bair told me, “Regulators are often nervous about centralized exchanges listing privacy coins because it breaks the link between fiat onramps and Web3 activity. Control and oversight of onramps and offramps is critical to extending the control and surveillance regulators already exert over the traditional financial system.”
In 2019, NYDFS responded to years of complaints that the Bitlicense slowed adoption of new products and services in New York by proposing a token approval procedure. The new procedure allows exchanges to bring their token listing policy to New York and, once approved, there is an automatic approval of tokens that the exchange puts through their process. This removed NYDFS involvement in approving coin by coin basis.
NYDFS Coin-Listing Process
NYDFS
There is just one problem. NYDFS explicitly stated, “Consistent with the intent and purpose of 23 NYCRR 200.15(g), a VC Entity cannot self-certify any coin that may facilitate the obfuscation or concealment of the identity of a customer or counterparty. Thus, for example, no privacy coin can be self-certified. A VC Entity also cannot self-certify any coin that is designed or substantially used to circumvent laws and regulations (for example, gambling coins).” (emphasis added).
NYDFS also offers a green list of tokens for New York but no privacy coins are included.
No privacy coins appear on the NYDFS pre-approval list
NYDFS
As Vik Sharma, founder of Cake Wallet, a noncustodial wallet for Monero, told me, “As NYDFS slightly opened the door for Bitlicense holders to more quickly list additional assets, they kept the door closed for ‘privacy coins.’ The issues with this decision remain: 1) ‘privacy coin’ is ill-defined, meaning it is applied based on optics instead of actual money laundering and terrorist financing risks, and 2) the vast majority of money laundering and terrorist financing risks remain on the Bitcoin network.”
“If a regulator were to allow the coins to be listed on its regulated exchanges, the regulator is endorsing the use of these coins and opening them up to many more users. Ironically, of course, if people are using privacy coins on an exchange, they’re far more traceable than between unhosted wallets.” – Jon Blattmachr, Deputy General Counsel of INX and former Virtual Currency Chief of NYDFS
Privacy Coins Outperform As Investments
While over the last two years the outlook for privacy coins appeared bleak from a regulatory perspective, and some such as Monero and Zcash were delisted from certain exchanges such as Bittrex and ShapeShift, privacy coins have still turned out to largely be strong investments. Especially so when compared to bitcoin.
Privacy coins are holding their own against bitcoin
TradingView
There are a couple of reasons for this. First, like most cryptocurrencies, privacy coins tend to move in the same direction as bitcoin. Second, many of these platforms have loyal followings that see these assets as more than just a transactional opportunity, but as a higher calling for a basic human right.
That said, because of their thinner trading volumes, and smaller usage rates, privacy coins may be more volatile than the base asset. Privacy coins are arguably an important tool of asset diversification in any portfolio provided that the regulatory climate does not tighten due to increased concerns about ransomware or other factors.
Outlook
What does the future of privacy coins look like in the US and internationally? Many would argue it will be similar to HTTPS and how the government eventually agreed with the need for privacy and encryption.
Industry groups and companies must continue to engage with regulators to discuss privacy coins, eliminate misconceptions, and responsibly articulate the value of financial privacy. These issues are unlikely to be solved anytime soon.
In Jon Blattmachr’s words, “Engagement with the regulators is paramount. Regulators are always going to be behind the curve when it comes to new technologies and iterations using those technologies. Regulators are understaffed and are not focused on what’s next, but what’s in front of them right now.”
That’s why industry engagement with regulators is so important. It allows the industry to show regulators that privacy coins are not as detrimental to AML efforts as perceived and alo explain how regulators can oversee in the space while still allowing for innovation.
The record-breaking NFT sale by Beeple in 2021 Q1 re-ignited market interest in NFTs after the initial foundation was laid out by the Cryptokitties project back in 2017. This was followed up by NFT projects like CryptoPunks and Board Ape Yacht club that soared in prices in a very short period of time. The sudden spike in market sentiment for NFTs made many investors millionaires overnight. That said, amidst all this excitement, NFT investors can easily fall victim to many tax pitfalls due to ambiguous tax guidance and lack of education on how to manage NFT taxes correctly.
Key Concepts
What are NFTs?
Non-fungible tokens (NFTs) are digital representations of assets — artwork, domain names, music, characters in games — created in limited quantities to maintain scarcity. Each NFT is unique and therefore not interchangeable with another in a similar manner to fungible digital assets such as bitcoin or ether.
For example, CryptoPunks is a collection of a thousand unique pixelated avatars with different facial features and characteristics. Since each character is unique, CryptoPunk #4835 is not interchangeable with CryptoPunk #5801.
You can buy and sell NFTs in dedicated marketplaces such as OpenSea, SuperRare and Nifty Gateway, among others. Additionally crypto exchanges like Binance, Coinbase, or FTX have announced or launched NFT platforms.
Tax Treatment of NFTs
How taxes work for NFT investors
NFT investors are individuals who buy and sell NFTs in marketplaces like OpenSea.They are subject to a similar set of tax rules (with some tweaks) as cryptocurrency investors.
How the IRS treats NFTs
Although the IRS has not issued any NFT specific tax guidance, most art-based NFTs such as CryptoPunks are likely classified as collectibles under the IRS § 408(m)(2)(A)). This tax classification is important to note because it subjects NFT gains to a slightly higher tax rate than regular cryptocurrency in some cases. Note that fractionalized NFTs will still preserve the same underlying tax classification.
When do Investors have to worry about NFT Taxes?
First, purchasing an NFT using a cryptocurrency like ether (ETH) triggers a taxable event. This is because you are disposing of a property to buy an NFT. For example, Sam spent 1 ETH to purchase a CryptoPunk valued at $5,000. Sam paid $100 to buy this ETH few years ago. Sam will have a $4,900 ($5,000 – $100) long term capital gain at the time he spends the ETH to buy the CryptoPunk. $5,000 will be his cost basis for the NFT.
Second, cashing out an NFT or trading one NFT for another also trigger capital gains tax events for investors. If Sam were to sell his CryptoPunk for 2 ETH valued at $12,000, he’d Incur a capital gain of $7,000 ($12,000 – $5,000)
Third, some NFTs also pay you royalties each time a subsequent sale occurs. In this case, royalties paid in cryptocurrencies are taxed when earned.
NFT Tax Pitfalls
You could owe NFT taxes without ever receiving cash
There are three situations where you could owe NFT taxes without ever receiving any cash in hand. These include purchasing an NFT using a cryptocurrency, trading one NFT with another and earning royalties in cryptocurrency. Unfortunately, most NFT holders are not aware of these rules. This could result in large and surprising bills come tax day, which you may not have the cash to pay.
You could incur penalties for not paying taxes on time
If you generated large amounts of profits from NFTs, you could have a quarterly tax obligation in 2021 for the first time. You may be unaware of this leading to underpayment penalties. To avoid getting penalized, you should consult with a tax professional to figure out your quarterly tax obligation or see if you qualify for a safe harbor.
At high-income levels, NFT gains could be subject to higher tax rates than you anticipated
A short-term capital gain occurs when you sell an asset after holding it for less than 12 months. If you are somebody who rode the NFT wave in 2021, most of your gains will be short-term. Short-term gains on NFTs can be subject to the maximum 37% If you are in the highest tax bracket. Also, be prepared to pay an additional 3.8% Net Investment Income tax if you exceed the applicable income thresholds for the year.
A long-term capital gain occurs when you sell an asset after holding It for more than 12 months. Generally, tax law favors long-term capital gains by subjecting them to a lower tax rate than short-term capital gains. The maximum long-term capital gains tax rate is 20% for stocks and cryptocurrencies (plus the 3.8% NII tax when applicable). Unfortunately, since NFTs are classified as collectibles, long-term NFT gains are subject to a maximum rate of 28% for high income earners.
Calculating NFT gains & losses is difficult
Currently, NFT marketplaces do not provide you with any tax documents nor any transaction history reports to figure out your NFT capital gains and losses. So, it is your responsibility to keep detailed records, figure out the correct cost basis & market values and accurately file taxes.
In the cryptocurrency world, there is tax software which helps you automatically reconcile capital gains & losses by connecting to your wallets and exchanges. However, when it comes to NFTs, the software support is at its infancy causing you to have to manually calculate taxes in some cases.
NFT Valuation concerns
NFTs are not like cryptocurrencies where you can actively see fair market values on websites like CoinGecko or Coinmarketcap. Therefore, if you trade one NFT with another, you will have to appraise the value of the receiving NFT to compute the accurate taxable gain or loss. Appraisal could become a big issue especially when the transaction amount is significant. Again, it is your responsibility to identify these events and seek professional help to accurately figure out your NFT taxes.
Next Steps
· Reconcile your NFT capital gains and losses.
· Consult with a qualified tax adviser and calculate your projected tax obligation for 2021.
· Determine If you are required to pay taxes quarterly or meet the safe harbor for 2021.
· If needed, liquidate some NFT’s and/or other cryptocurrencies into cash to cover the upcoming tax bill
