What Financial Advisors Need to Know About Crypto Taxes

Cryptocurrency has been slow to gain favor with independent financial advisors, who tend to view digital assets with skepticism. Meanwhile, as more and more people trade bitcoin and its brethren, they face some thorny tax issues this reporting season that may impact their long-term financial planning.

Advisors with a “holistic” approach to everything from paying for college and buying a home to retirement and estate planning often don’t have answers to the crypto questions clients ask. But with a fiduciary duty to act in a client’s best interest, they are obligated to understand the confusing and murky tax treatment of digital assets, whether they are recommending them or offering access to them. At stake can be unexpected tax bills that eat into an investor’s nest egg and scrutiny of a planner’s practices.

“The biggest problem for crypto and tax advisors is that many advisors aren’t properly trained in this area,” said Ric Edelman, who stepped aside of his $291 billion independent consulting firm of the same name, Edelman Financial Engines, last year. “Some crypto taxes are the same as for other assets, which all advisors are familiar with, like capital gains,” he said. “But many other areas are new and different.”

The growing scrutiny from the IRS over whether investors are disclosing their transactions comes as investors pile more money into crypto. The holdings of the top 100 coins were worth almost $1.7 trillion in January 2022, according to Morningstarand bitcoin’s market capitalization would rank in the top 10 largest companies in the S&P 500. Yet, at tax time, most investors don’t receive a standard form, as they do for stocks, detailing what they bought and sold during the previous period. year.

Some 14% of advisors used or recommended crypto to clients in 2021, the Financial Planning Association, a trade group, mentioned in June 2021. Just over one in four advisors said they plan to increase their usage or referrals this year, with nearly half, or 49%, saying clients have asked them about cryptocurrencies in the previous six months.

As digital assets are increasingly accepted by banks and brokerages on Wall Street, including Goldman Sachs and Merrill Lynch (this is now explore the supply of digital assets after ban his advisers in 2018 to touch them), here’s how independent advisors can add value on the crypto front, even if they don’t like the digital asset class.

Question from Zinger:
On this year’s form 1040 (which is scheduled for April 18), the IRS asks a pointed question upfront: “At any time in 2021, did you receive, sell, trade, or otherwise dispose of a financial interest in a virtual currency?” Taxpayers must check “yes” or “no” under penalty of perjury. It sounds simple, but it’s complicated.

In a long and separate tip sheet on how to answer the question, the agency says that “if your only transactions involving virtual currency in 2021 were virtual currency purchases with real currency, you don’t have to answer ‘yes’ to the Form 1040 question, and should instead, check the “no” box. This is confusing, as it appears to contradict the Form 1040 question of whether a taxpayer received, sold, traded, or otherwise disposed of crypto.

Under its sole guidance, issued in 2014, the IRS considers cryptocurrency not to be money, but rather “property,” like stocks, gold, real estate, and the art of collection. Stocks and real estate are taxed at the capital gains rate, now as high as 23.8%. Collectibles are taxed at a maximum of 28% upon sale (resellers pay higher ordinary income tax rates when selling items from their inventory).

Here’s where things get murky. The agency does not indicate what happens tax-wise when common events in the crypto world, such as “mining” and “forks,” to happen. Mining involves people using powerful computer networks to authenticate and process crypto transactions by solving mathematical problems that require millions of calculations. People using this blockchain technology are rewarded with digital coins for their work. A fork occurs when a cryptocurrency splits in two, which happens when software developers change the rules underlying the blockchain. These events – or others, such as staking (depositing crypto to earn interest, often through a digital platform like Coinbase or Binance) and airdrops (when crypto magically appears in an investor’s digital wallet as part of a marketing campaign) create taxable income?

Since 2014, the IRS hasn’t weighed in. Kyle Waterbury, a private wealth planner at Unique Wealth, an independent firm in Tampa, Florida, said: “There is a lack of clarity on the regulatory elements. Do we treat a transaction from a non-custodial portfolio as a taxable distribution or as a transfer in kind? It’s a bit of a black box. »

Some accountants take the conservative approach of treating these events as creating income now taxable at ordinary and basic rates, or the amount they originally paid, to account for capital gains tax on profits on subsequent sale.

“Elephant in the Room”
Because the IRS views crypto as property, it does not view it as a security, such as a stock or mutual fund. (Meanwhile, another branch of the Treasury Department considers them subject to anti-money laundering rules, and therefore a form of currency subject to those rules).

Thus, for tax purposes, the wash sale rule, to take a deduction for selling losing stocks while quickly picking up those same or “substantially identical” stocks, does not apply to crypto trades. The rule, which aims to prevent investors from selling at a loss just to generate a tax deduction, states that investors must wait 31 days to redeem the same or substantially identical asset.

Except that in a few cases, the wash sale rule would apply to digital assets. In a closely watched court case, the Securities and Exchange Commission in December 202 for follow-up Ripple Labs, a digital payments company, said its XRP cryptocurrency should have been registered as a security – and therefore subject to the washout rule – because its digital tokens are “investment contracts”.

Last month, President Joe Biden sign an executive order directing various branches of government to explore crypto regulation, with the primary goal of protecting investors and consumers. SEC Chairman Gary Gensler mentioned On April 4, the government regulator would seek to oversee crypto exchanges in the same way it does traditional platforms like the New York Stock Exchange.

This in turn will lead to greater scrutiny of the major investment advisory firms he oversees, according to law firm Vela Wood. “Most RIAs are not equipped, or have the resources available, to manage these new assets,” firm attorney Lacey Shrum wrote in an undated post on the company’s website. “However, it’s obvious that the SEC is starting to take a look and see how the advisers are reaching out to the new elephant in the room.”

Dude, where’s my base?
Elliott Brack, a chartered accountant and managing director of tax services at Manhattan West, an independent consulting firm in Los Angeles, said getting clients to confirm transaction details was his biggest hurdle. Edelman, co-founder of the Digital Assets Council for Financial Professionals, a research and education organization, said “relatively few” trading platforms send clients the detailed 1099 forms needed to calculate their gains and losses at tax purposes.

But if investors can use a tracking service like ZenLedger to do the job, they might not know it. “They say, oh, I didn’t get a 1099 – lovely! I have nothing to report to the government,” Brack said – a mistake that can result in an IRS audit.

The agency will require crypto exchanges to send forms to investors starting in 2023. Treasury Secretary Janet Yellen mentioned On April 7, investors “should receive the same type of tax reporting on digital asset transactions that they receive for stock and bond transactions.” But even these forms may not help investors calculate their basis before selling.

Dark areas of disclosure and regulation are vexing to Edelman, a crypto proponent“This is a very frustrating scenario for advisors and owners of these assets.”