What financial advisors need to know about crypto taxes this filing season

Cryptocurrency has been slow to gain favor with independent financial advisors, who tend to regard digital assets with skepticism. Meanwhile, as more people trade bitcoin and its brethren, they’re confronting thorny tax problems this filing season that can impact their long-term financial planning.

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

“The biggest issue for advisors regarding crypto and taxes is that many advisors are not properly trained in this area,” said Ric Edelman, who stepped away from his $291 billion namesake independent advisory firm, Edelman Financial Engines, last year. “Some crypto taxation is 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 IRS’s mounting scrutiny of whether investors are disclosing their trades comes as investors pile more money into crypto. Holdings of the top 100 coins were worth nearly $1.7 trillion as of January 2022, according to Morningstar, and the market capitalization of bitcoin would rank in the top 10 largest companies in the S&P 500. Yet come tax time, most investors don’t receive a standard form, as they do for stocks, detailing what they bought and sold during the prior year.

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Some 14% of advisors either used or recommended crypto to clients in 2021, the Financial Planning Association, a trade group, said in June 2021. Just over one in four advisors said they planned to increase their use or recommendation this year, with nearly half, or 49%, saying clients had asked them about cryptocurrencies in the prior six months.

With digital assets gaining acceptance by Wall Street banks and brokerages, including Goldman Sachs and Merrill Lynch (it’s now exploring offering digital assets after banning its advisors in 2018 from touching them), here’s how independent advisors can add value on the crypto front, even if they dislike the digital asset class.

Zinger question:
On this year’s Form 1040 (which is due April 18), the IRS shoots a sharp question straight out of the gate: "At any time during 2021, did you receive, sell, exchange or otherwise dispose of any financial interest in any virtual currency?” Taxpayers must tick either “yes” or “no” under penalty of perjury. Sounds straightforward, but it’s complicated.

In a separate, lengthy tip sheet on how to answer the question, the agency says that “if your only transactions involving virtual currency during 2021 were purchases of virtual currency with real currency, you are not required to answer “yes” to the Form 1040 question, and should, instead, check the “no” box.” That’s confusing, because it appears to contradict Form 1040’s question of whether a taxpayer received, sold, exchanged or otherwise disposed of any crypto.

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

Here’s where things get murky. The agency doesn’t indicate what happens on the tax front when events common in the crypto world, such as “mining” and “forks,” occur. Mining involves people using networks of high-powered computers to authenticate and process crypto transactions by solving mathematical problems requiring zillions of calculations. People using that blockchain technology are rewarded with digital coins for their work. A fork is when a cryptocurrency splits into two, which happens when software developers change the rules underlying the blockchain. Do those 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 out of nowhere in an investor’s digital wallet as part of a marketing drive) 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 that “There’s a lack of clarity on the regulatory pieces. Do we treat a transaction from a noncustodial wallet as a taxable distribution or as an in-kind transfer? It’s a little bit of a black box.”

Some accountants take the conservative approach of treating those events as creating income now taxable at ordinary rates, and basis, or the amount they originally paid, to tally capital gains tax on profits when later sold.

‘Elephant in the room’
Because the IRS sees crypto as property, it doesn’t consider it to be a security, like a stock or a mutual fund. (Meanwhile, another branch of the Treasury Department regards them as subject to anti-money laundering rules, and thus as a form of money subject to those rules).

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And so for tax purposes, the wash sale rule, from taking a deduction for selling losing stocks while quickly scooping up those same shares or ones “substantially identical,” doesn’t apply to crypto trades. The rule, which is designed to prevent investors from selling at a loss just to generate a tax deduction, says investors have to wait 30 days before or after a sale to repurchase 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 legal case, the Securities and Exchange Commission in December 202 sued Ripple Labs, a digital payment company, saying that its XRP cryptocurrency should have been registered as a security — and thus subject to the wash rule — because its digital tokens are “investment contracts.”

Last month, President Joe Biden signed an executive order directing various branches of government to explore regulations for crypto, with the primary aim of protecting investors and consumers. SEC Chairman Gary Gensler said April 4 that the government regulator would seek to oversee crypto exchanges the same way it does traditional platforms like the New York Stock Exchange.

That in turn will lead to greater scrutiny of the large investment advisory firms it oversees, according to law firm Vela Wood. “Most RIAs are not equipped, nor have the resources available, to handle these new assets,” firm lawyer Lacey Shrum wrote in an undated post on the company’s website. “However, it is apparent that the SEC is starting to take a look around and see just how advisors are addressing the new elephant in the room.”

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

But while investors can use a tracking service like ZenLedger to do the job, they might not know about it. “They say, oh, I didn’t receive a 1099 — sweet! I don’t have to report anything to the government,” Brack said — a mistake that can prompt an IRS audit.

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

The murky disclosure and regulatory areas are vexing to Edelman, a crypto proponent: “It’s a very frustrating scenario for advisors and owners of these assets.”