Understanding IRS Rules for Reporting Digital Assets

As digital assets like cryptocurrency continue to gain popularity, the IRS is paying closer attention to how these transactions are reported on tax returns. With this area flagged as a priority for enforcement, it’s important for taxpayers to understand the rules and stay compliant to avoid costly penalties. Here's a breakdown of what the IRS expects when it comes to digital asset reporting.

What is a Digital Asset?

The IRS defines digital assets as digital representations of value recorded on a cryptographically secured distributed ledger (commonly known as a blockchain) or similar technology. This includes cryptocurrencies like Bitcoin and Ethereum, stablecoins pegged to a fiat currency (such as the U.S. dollar), and non-fungible tokens (NFTs), which represent ownership of unique items.

How to Answer the Digital Asset Question on Your Tax Return

Each year, the IRS requires taxpayers to answer a question on their federal income tax return: Did you receive, sell, exchange, or otherwise dispose of any digital assets during the year?

A “yes” or “no” is required.

Answer “yes” if, for example, you received digital assets as payment or rewards, acquired them through mining or staking, exchanged one type of digital asset for another, or sold crypto for cash or services.

Answer “no” if you only held crypto, moved it between wallets, or purchased it with U.S. dollars.

Tax Treatment of Digital Asset Transactions

The tax impact of a digital asset transaction depends on the fair market value (FMV) in U.S. dollars at the time of the event. Your cost basis is typically the amount you paid for the asset. If you sell a digital asset for more than your basis, you realize a gain. If you sell it for less, then you would record it as a loss. These gains or losses are treated as short- or long-term depending on how long you held the asset.

Let’s look at an example. Say you traded a car with a $55,000 basis for one Bitcoin (worth $80,000) and $10,000 cash. You’d report a $35,000 gain, which reflects the difference between the Bitcoin’s worth (plus the $10k cash) and the basis of the car. The length of ownership of the car will determine if the loss should be reported as a short-term or long-term gain.

The length of ownership of the car will determine if the loss should be reported as a short-term or long-term gain.

Digital Asset Payments in Business

Businesses and individuals who receive payments in crypto must also report the income correctly. Employees paid in cryptocurrency must report the FMV as wages on Form W-2, subject to payroll taxes. Independent contractors must report it as income on Form 1099-NEC if total payments exceed $600.

Claiming Crypto Losses and the Wash Sale Rule

Digital assets are treated as property for tax purposes, so the wash sale rule (which disallows a loss deduction if you repurchase a security within 30 days) currently doesn’t apply to crypto. That means you can sell crypto at a loss and buy it back immediately, still claiming the loss. However, this rule does apply to crypto-related securities, such as stock in a cryptocurrency exchange.

Crypto and Form 1099 Reporting

You may receive a variety of tax forms based on your crypto activity, including Form 1099-MISC, 1099-K, 1099-B, or the new Form 1099-DA. These are also sent to the IRS, so it’s essential to ensure that your tax return matches the information reported.

Stay Ahead of Evolving Rules

Digital asset tax rules are complex and continue to evolve. Keep thorough records of your transactions, including dates, amounts, FMV, and cost basis. If you have questions or need help navigating these requirements, reach out to us. Staying organized and informed can help you avoid IRS scrutiny and file with confidence.