IRS Adds New Guidance But Form 1040 Cryptocurrency Question Is Still Causing Confusion

The IRS really wants to know about your cryptocurrency. For tax year 2020 the IRS moved the cryptocurrency question from Schedule 1 of the Form 1040, where it was in 2019, to the much more prominent position of Page 1 of the Form 1040 itself. The question is the second piece of information requested, right after the taxpayer’s name and address. The question reads as follows: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” The draft instructions for Form 1040 indicated that if you purchased cryptocurrency you should answer yes to the question. The final Form 1040 instructions, however, removed the examples that indicated taxpayers who purchased cryptocurrency should answer yes to the question. The question itself remained unchanged.

On March 2, 2021 the IRS issued new guidance (by updating Question 5 of its Frequently Asked Questions or FAQ) that states “If your only transactions involving virtual currency during 2020 were purchases of virtual currency with real currency, you are not required to answer yes to the Form 1040 question.”  FAQs are not considered authority when taking a position on a tax return and FAQs change frequently. Relying on FAQs for bulletproof guidance is risky. At a minimum, tax professionals recommend the best practice of printing a dated copy of the relevant FAQ into the client’s tax file. If you do your own taxes, keep a hard or electronic copy with your other tax documents (W2s, etc.).

The updated guidance is causing consternation among taxpayers and tax professionals because it has changed from the original guidance and because it is confusing. People (including many tax practitioners) are wondering why taxpayers are allowed to answer no to the question when, if they purchased cryptocurrency with real currency during the year, they clearly received or acquired a financial interest in cryptocurrency during the year.

The confusion comes from the combination of a wordy and somewhat ambiguous question combined with changes to the guidance. I don’t think many taxpayers pay attention to draft instructions but tax practitioners do. Consequently, the disappearance of the “answer yes if you purchased cryptocurrency” examples in the 1040 instructions combined with the recently updated FAQ is creating confusion that at times seems to border on panic. In general tax professionals are a cautious bunch who prefer bright line answers. This is the kind of situation that makes their eyes twitch.

Nevertheless, it is important to consider both the current authority surrounding cryptocurrency transactions, which admittedly amounts to “not much” and what the IRS is trying to accomplish with this question. They are trying to determine if the taxpayer had any taxable transactions related to cryptocurrency. Buy and hold is not a taxable transaction.

According to guidance provided by IRS Notice 2014-21, cryptocurrency is not treated as currency in the eyes of the IRS. It is treated as a capital asset and is, for the most part, treated in a manner similar to stock transactions. Understanding this and the important concept of how accession to wealth can create taxable income may help to clear up the confusion. The IRS is looking for sales of cryptocurrency that could generate capital gains and losses. They are also looking for receipt of cryptocurrency that constitutes payment for services, gifts, airdrops, etc.

Payment for Services—When taxpayers receive cryptocurrency as payment for providing services it is often going to be considered self-employment income (unless it is hobby income, which is well beyond the scope of this article). Income from self-employment is usually reported on an individual’s 1040 using Schedule C and often results in self-employment tax (the taxpayer’s Social Security and Medicare taxes) in addition to income tax.

Gifts—Gifts of cryptocurrency (or pretty much anything else) are not taxable to the recipient. According to Duberstein v. Commissioner gifts are only gifts if they are given out of “detached and disinterested generosity” and out of “affection, respect, admiration, charity or like impulses.”  Gifts may require the giver to complete a gift tax return and possibly to pay gift tax. The IRS will also be on the lookout for gifts that are really disguised taxable compensation or payment for other property or assets.

Airdrops—Airdrops are perhaps best compared to the legal concept of treasure trove. Airdrops are, effectively, found money. And found money (that duffel bag of dollars you found on the side of a desert highway) is reportable and taxable as income. So are airdrops. Drops of cryptocurrency that simply show up in your account or wallet are taxable events. If you receive an airdrop answering yes to the cryptocurrency question is a given.

Generally speaking, cryptocurrency trades are reported the same way stocks are—by using Form 8949 and Schedule D with a Form 1040. Short-term gains are taxed as ordinary income. Long-term gains get the more favorable capital gains tax rates. The IRS does not expect taxpayers to report every single stock purchase they make at the time they make it if they do not sell or otherwise dispose of it. They do, however, expect taxpayers to track their purchases (date, basis or purchase price, and number of units) so that when the stocks are sold the proper holding period (short- or long-term) and the gain or loss on the sale can be accurately determined.

It’s this writer’s opinion that the IRS says that taxpayers can answer no to the cryptocurrency question on Form 1040 if all they did was use real currency to buy a given amount of cryptocurrency because cryptocurrency transactions are, for the most part, treated like stock transactions. This is not to say that the IRS is uninterested in people who are merely holding cryptocurrency. They have made it clear that they are quite interested but they have other ways of obtaining that information and, at least for the largest holders, they are using them. So while you can answer no to the question, should you answer no? The answer to that question depends on your trading habits and your risk tolerance and is something that should be discussed with a trusted tax professional. And if you are holding a large amount of cryptocurrency and/or doing a high volume of trading it’s best to find a tax professional who specializes.