Making a Killing in Cryptocurrency? There’s a Tax on That

The number of people investing in cryptocurrency in recent years seems to be ever-increasing. Several years ago, almost no clients came to us with cryptocurrency in their portfolios. These days, even retirees seem to have it in their portfolio. In our previous article, we talked about generally considering cryptocurrency in your estate plan. This time, we’re going to be talking about the general estate and gift tax implications of cryptocurrency, as well as cryptocurrency reporting and valuation issues. 

What is cryptocurrency? It’s a virtual currency (or a digital representation of value that functions as a medium of exchange or store of value). Cryptocurrency has an equivalent value in real currency, or can act as a substitute for it, and can be traded to be purchased for or exchanged into U.S. dollars, euros and other real or virtual currencies. However, it is not treated as legal tender in the United States. There are many different types of cryptocurrencies; right now, the top cryptocurrencies include Bitcoin, Ethereum, Binance Coin, Tether and Solana.

In the current landscape, the volatility in the value of many digital assets is an example of the risk of investing in these assets. However, because there is the potential for growth again, estate planning opportunities exist.

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If you sell cryptocurrency, your gains will be taxed

Just like with any assets, when you sell cryptocurrency, you must recognize a gain or loss on the sale. In this sense, dealing with cryptocurrency is the same as selling stocks, bonds or mutual funds. The same general capital gain-and-loss rules apply. You’ll pay ordinary tax rates on short-term capital gains for assets held under one year, and for assets held for over a year, you’ll pay long-term capital gains tax, likely at a lower rate.

If you gift cryptocurrency, the gift tax exemption applies

A gift of cryptocurrency is treated the same as other gifts. In 2022, if you gift less than $16,000 worth of cryptocurrency to another individual in a calendar year, this gift transaction will fall below the annual gift tax exemption amount under federal law. You will not need to file a gift tax return or use up any of your available lifetime federal gift tax exemption amount (currently $12.06 million) when you make the gift.

If you are married, you can combine your and your spouse’s annual gift tax exemption amounts to give up to $32,000 of cryptocurrency per person per year. However, if you gift more than $16,000 to anyone in a year (or $32,000 if your spouse elects for gift splitting), you will be required to fill out a gift tax return (IRS Form 709). 

Crypto is treated as property when you die

The IRS treats cryptocurrency as property for tax purposes (not currency), and therefore, the same federal and state estate tax rules apply to cryptocurrency that apply to stocks, bonds, mutual funds and real estate, for instance. When someone dies owning cryptocurrency, an appraisal will be necessary to determine the value of the asset at death, and the asset will get a stepped-up basis equal to the fair market value of the cryptocurrency at death.

In practice, most cost basis adjustments after death result in an increase in tax basis (not decreases) because assets given at death are often long-term holdings and tend to have positive long-term rates of return. So, if you purchased Bitcoin for $1, and when you die it’s worth $400,000, your heirs will inherit the $400,000 basis. The fair market value at your date of death will be the value includible on your estate tax return, if one is needed.

IRS reporting requirements coming for cryptocurrency

Under the Infrastructure Investment and Jobs Act (HR 3684), signed by President Joe Biden on Nov. 15, 2021, cryptocurrency brokers are now required to collect detailed information, including customer names, addresses, losses and gains and the customer’s trade, to comply with increased IRS reporting requirements. The law will be effective in January 2023 with companies required to begin sending reports to clients and the IRS in 2024. The purpose of the requirements is to make it easier for cryptocurrency investors to do their taxes and for the IRS to reduce tax-evasion concerns.

It is worth noting that the IRS is considering delaying implementing this cryptocurrency reporting; however, no official statement has been released or confirmed.

Valuation doesn’t follow the usual rules

The cryptocurrency market is volatile and is not valued the same as the U.S. dollar or other currencies managed by a government. The main theory behind cryptocurrency value is if enough people think it is valuable, then it becomes more valuable. Without regulation, demand causes fluctuations and sometimes extreme changes in value depending on supply, demand, utility and competition. Several models have been proposed to determine cryptocurrencies’ value, resulting in many valuations and underscoring the challenge investors face when valuing these currencies.

Many estate planning techniques, including making gifts to family members or trusts and making charitable donations at death require valuations of the property given away. In addition, there are companies that will perform valuations of cryptocurrency for estate planning purposes (for example, Redwood Valuation and Eqvista), and there are various approaches to value these unique assets (for example, market approach, income approach, cost approach and quality theory of money).

You can lower cryptocurrency-related taxes

Ways to lower taxes associated with cryptocurrency:

• Donate to charity to obtain a charitable income tax deduction.
• Offset cryptocurrency gains with other capital losses.
• Sell assets during a low-income year.
• Regular gifting (either directly to individuals or through the use of irrevocable trusts).

Think carefully about how you’d like to transfer ownership of your cryptocurrency and the potential tax implications.

Cryptocurrency is a volatile, interesting and complicated asset with many pitfalls to consider before transferring ownership. However, under the right circumstances, cryptocurrency can be a valuable asset with which to plan to transfer wealth to your loved ones. Be sure to work with advisers who are aware of all of the complications in order to achieve the best results with your planning.

Tracy A. Craig is a partner and chair of Seder & Chandler's Trusts and Estates Group. She focuses her practice on estate planning, estate administration, prenuptial agreements, guardianships and conservatorships, elder law and charitable giving. She works with individuals in all areas of estate and gift tax planning, from testamentary estate planning and business succession planning to sophisticated lifetime leveraged gifting techniques, such as grantor retained annuity trusts (GRATs), intentionally defective grantor trusts, family limited liability companies and qualified personal residence trusts (QPRTs). Tracy serves in various fiduciary capacities, including trustee and personal representative (formerly known as executor). She also works with clients on issues facing elders.

Emily Parker Beekman is a Wealth Planning Advisor at CI Eaton Private Wealth in Boston. She works with clients and their advisors to develop and implement their estate planning, wealth transfer and charitable planning strategies. Prior to entering the wealth management field, Emily spent 10 years as a practicing trusts and estates attorney, where she assisted clients and generations of families regarding estate planning, estate and gift taxes, probate law, probate avoidance, estate and trust administration, philanthropy and specialized in estate planning for disabled persons, guardianship and conservatorship matters and long-term-care planning and other elder law matters.