You Could Lose Big Money on Crypto If You Don't Know These Tax Laws

In this clip from "The Future of Fintech" on Motley Fool Live, recorded on Feb. 10, Motley Fool contributors Matt Frankel, Jason Hall, and Will Healy discuss how the IRS treats cryptocurrency and what investors should know and understand when filing their taxes and reporting crypto gains and losses.

Matt Frankel: The IRS has been treating cryptocurrency the same way for several years now. As I just mentioned, they treat it as property just like if you were to buy a stock, or buy a piece of art, or buy anything else that could appreciate in value where it's treated under capital gains tax law if you sell it at a profit. It could be considered a capital loss, if you sell it at a loss. It's not just if you buy and sell cryptocurrency, which is the problem, it's if you buy cryptocurrency and then use it to pay for something later on and the value of that cryptocurrency has changed. Let's say I buy $5 worth of Bitcoin (BTC -3.46%) today. In three months, that $5 worth of Bitcoin is worth $10 and I use it to buy a $10 t-shirt at the mall. I have to pay tax on that $5 difference between what I paid for the Bitcoin and the value I got from my purchase. That could be a logistical nightmare if you're using it for all of your spending. Jason, you mentioned you own some Bitcoin and I think you said Ethereum (ETH -1.17%). Have you had to do the tax nightmare with it yet?

Jason Hall: Not yet. I haven't done my taxes for 2021 and I made my first purchases early last year. I've never sold, so there's no realized gains or losses or anything. So, I think it should be pretty straightforward for me this year.

Frankel: Go ahead, Will.

Will Healy: I think it's good that they've formalized it because they were always taxing, going back to 2014 anyway. They said explicitly it is subject to taxes. So, it is treated like a stock. It helps that they formalize it, but I don't know if it really makes that much of a difference other than that.

Frankel: They've been very clear that it's treated as a capital asset, like Will just said. But the one big problem is, the cryptocurrency community skews younger. It's people who aren't too familiar with taxes in general or tax law in general. A lot of people just simply don't know that they have to pay tax when they spend cryptocurrency, even when they sell cryptocurrency. A lot of people don't realize that it could be a taxable transaction. The IRS is making it very clear this year, and I want to show you this. This is the big change this year. It's not a change in the law, it's just a change in awareness from the IRS. If this is the actual 1040 for 2021, I haven't filed my taxes yet, I don't know if either of you have, but when you do, the 1040 looks like this. If you look under the boxes with your name and things like that, there's a line right before you even get to the standard deduction, right on top of the standard deduction box. This is at any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency? They are making clear in no uncertain terms that you need to disclose that before you even get to your marital status. It's right up there on the top of the 1040. I got to say, I was surprised that they made this so prominent this year. Did it surprise you guys or do you think that there is really that much leakage when it comes to cryptocurrency and taxes that they needed to put it right out in the top of the form?

Hall: It's more of a couple of things. One is making it abundantly clear. Two, to start making a part of the tax preparation process. That's probably a big part of it. There's also just a lot of legitimizing of digital currencies that this does too, and that that's going to carry weight maybe for investors who haven't, I don't think this was the IRS intent, but for people who haven't necessarily invested in crypto in the past. You see it right there prominently on the tax form. It's going to make you think a little bit, maybe this is a real thing. But at the end of the day, it costs a rounding error of zero to add this to the form. Any moneys that it brings in additional tax revenues is a huge return on that cost. I think that's the big thing. It's going to generate billions of dollars in revenue for the federal government. So, from that perspective, it makes sense to do it.

Healy: No matter which party is in power, we all know that they need money. [laughs] They're going to try and grab every dime that they can. I think it will help them in that respect anyway, even though it is a little strange to put it right there when regular capital gains are on some other form that a lot of people don't even see frankly.

Frankel: It's really interesting that they did this to me. The IRS releases tax payer data a little over a year after the filing deadline usually. We'll actually get some really good data on the percentage of Americans that do own and regularly transact in cryptocurrency, because, in my mind, it's a really low percentage. But if they feel the need to put this up there, they are thinking it's a pretty significant amount of Americans that are currently regularly using cryptocurrency or spending it or trading it, especially now that it's so easy to do in the Robinhood (HOOD 0.97%) app to just buy and sell it in a second if you want to. How many people are doing that and not paying the taxes due on it? Because, it could really add up. Like Jason said, it's a rounding error for the cost to the IRS.

Hall: I would have to guess that the big trading platforms like Gemini and Coinbase (COIN 3.02%) and those probably pushed for the IRS to do this because, at the end of the day, it could be a path for them to create more competitive advantage versus trying to have a digital wallet and totally manage all of this on your own that's not tied to any of these platforms, because if they can help you figure out your cost basis, that would be hugely beneficial to the centralized platforms that right now are mainly just there for trading. But, if they can also start helping out with figuring out your transactional cost basis, there's a lot of power there for those guys.

Frankel: In the 1040 instructions, the IRS goes really into virtual currency. I'm not going to read this whole thing to you, but you can see this section right here on virtual currency and here's the key. I don't know if you can see where I'm highlighting right now. If you received any virtual currency as compensation for services, so if you got paid in cryptocurrency at some point, that's another key. A lot of people are saying, "I'm going to get paid in Bitcoin and avoid the IRS," or dispose of any virtual currency that you held for sale to customers and a trader business, you must report that income as well. There are a lot of little nuances with cryptocurrency that have tax implications. You can see this whole list right here. A lot of people don't even know what all of this stuff means. Look at the fourth bullet down, the receipt of virtual currency as a result of a hard fork. Guys, do you know what that means?

Healy: The IRS too has limited resources to go after people who don't pay their taxes correctly. It's easy to tell yourself, if I'm using virtual currency, I don't have to pay it. I'm sure there's a big problem with enforcement and that has prompted this as well.

Frankel: By the way, a hard fork is when it's essentially a stock split of cryptocurrency. Years ago, Bitcoin did a hard fork where holders got a Bitcoin cash token for every Bitcoin that they held. That's what a hard fork is if you've got like a spin-off in cryptocurrency. If that happens, you have to pay taxes. If you mine cryptocurrency, you need to pay taxes. A lot of my Bitcoins were mined. Fortunately, that was a couple of years before the IRS gave any guidance on it whatsoever. [laughs] It didn't have that much value at that point anyway.

Hall: Matt, maybe this whole thing is Jack Dorsey. Maybe he's actually Satoshi Nakamoto.

Frankel: That would make sense.

Hall: He secretly is sitting on a ton of Bitcoin and that's why he's trying to push Block (SQ -8.44%) and Square completely in that direction.

Frankel: That would make his infatuation with Bitcoin make a lot more sense.

Hall: Could be, follow the money.