It’s Tax Time Again. Do We Really Know What That Means for Crypto?

April showers are falling, the spring flowers are blooming once more, and the deadline to file 2021 tax returns is just around the corner – but this year, many Americans are facing more complicated tax questions than ever before.

Blame for the complicated tax picture can be spread around. For example, COVID-19 tax breaks and stimulus payments had tax implications of their own, and work from home and remote work mean that more of us are working multiple jobs with a more complicated income picture.

Yet some of the blame has to be placed on the surging popularity of digital assets and decentralized finance (DeFi) strategies that use those assets to generate income – and on the lack of clarity on how such assets and income should be treated for tax purposes.

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“The biggest issue is how little IRS guidance there is out there,” said Nancy Dollar, a tax attorney with Hanson Bridget, a diversified law firm and family office. “You can list on one hand what they’ve put out; most of it is extremely vague and doesn’t address a lot of crucial issues.”

Hanson Bridget has experienced a steady increase in clients with crypto tax questions, Dollar said, many of them early investors in digital assets, and the firm generally renders advice in line with guidance from the Internal Revenue Service that treats cryptocurrency as property.

Many clients come to Hanson Bridget having engaged in various investment solutions completely absent of guidance and without an understanding of the implications of the IRS’s treatment of digital assets, said Dollar.

“When you deal in crypto, you recognize a gain or loss on the disposition of that property, it’s not like spending currency,” Dollar said. “In foreign currency, you don’t have to recognize a gain if you use that currency to buy a cup of coffee, but in crypto you do.”

In part, the vagueness and confusion in IRS guidance is likely by design, Dollar said, as much of the agency’s documentation was written to try to prevent taxpayers from using cryptocurrencies in tax-deferred 1031 exchanges, which are used for real property.

“That guidance went through every type of crypto widely available at the time and discussed how bitcoin was different from ether, which was different from litecoin and Ripple, analyzing all of these types of crypto to make its point that these weren’t like-kind properties, so you couldn’t sue a tax-deferred exchange,” Dollar said. “But in doing that, they showed they were willing to engage on the unique characteristics of each cryptocurrency –and people are now taking that ball and running with it.”

Many questions would be answered by a decision in what has come to be known as “the Jarrett Case.”

Joshua and Jessica Jarrett were involved in staking on the Tezos network in 2019 and received about $9,407 worth of Tezos tokens that they didn’t sell or exchange that year. On their initial 2019 tax return (filed in 2020), the Jarretts reported those tokens as “other income” but filed an amended return later in the year taking the position that the tokens weren’t income in 2019 because they weren’t disposed of in that year, claiming a refund of nearly $3,300.

After the IRS didn’t issue a refund or respond to the Jarretts’ request, they filed a complaint last year in district court requesting their refund. At issue was whether tokens created and earned through staking should be considered income in the year in which they are created.

“The baker analogy is the most quoted in our world – you don’t tax the baker when they bake the cake, you tax them when they sell it,” David Sacarelos, a CPA at the accounting firm Seiler LLP, said.

“The theory at work here is that proof-of-stake coins are either the creation of property or the receipt of property,” he said. “Are they capital and some labor, or does the baker analogy mean the coins are inventory and if you sold them they are taxed as ordinary income and not capital gains? The IRS needs to decide if this is potentially the return of capital or something like that.”

Read more from CoinDesk’s Tax Week coverage.

Should earnings from staking or mining cryptocurrency be taxed at the point at which they are received, or when they are disposed of? It may take longer than expected to find out. In February, the IRS capitulated and sent the Jarrett’s their tax refund, with interest.

While the Jarretts have tried to reject the refund and request a decision in the matter, the IRS filed for a dismissal of the case at the beginning of March.

“It carries huge consequences for anyone engaging in mining or staking activities,” Dollar said. “If the IRS position is that it’s all taxable income at the time of creation, you’re currently taxed on any token rewards as they are earned before you dispose of them. Proponents of crypto take issue with that, even if you don’t buy the taxpayer-created property argument, a lot of these tokens are functioning in an inflationary environment where in staking there’s dilution when people create tokens, it’s more akin to a stock split – the units increase, the value technically decreases.”

So what certainty can clients have in the vague world of crypto taxation, aside from the inevitability of governments finding ways to derive revenue from digital assets?

“It’s still safe to say we’re in a rising-rate environment; the capital gains rate has been discussed as a potential source of additional income, and this is not a situation where we would expect tax rates to go down,” Sacarelos said. “Maybe this is a year that we look at our crypto investment assets and consider whether it is time to realize some of those gains and diversify.”

There are also opportunities for proactive estate tax planning with digital assets, Dollar said.

“In terms of planning, this is a very volatile environment,” Dollar said. “One opportunity I see for those who have significant enough wealth to do tax planning around their estate plan is to consider using crypto in what are called grantor-retained annuity trust (GRAT). These are estate-planning vehicles that allow for the transfer of wealth and operate very favorably when you have a highly volatile asset.”

In a GRAT, the grantor puts assets into the trust and receives regular income payments in the form of an annuity stream, while the assets are allowed to appreciate and transfer to heirs with little or no estate taxes levied.

In the meantime, don’t expect a lot of additional information from the IRS, Sacarelos said.

“The IRS is under pressure because of declining service levels; they’re hoping to catch up from 10 million past tax returns and 18 million unprocessed pieces of paper before the end of this calendar year, but they’re so backed up right now,” he said. “They’re doing the best they can, but if we’re looking for clarification or meaningful reform from the ground up, I don’t know if that’s possible right now.”