Income Tax Day is fast approaching, and taxation authorities around the world are anxious to cash in on cryptocurrency. Not their cryptocurrency, of course, but yours. The burgeoning crypto sector represents a goldmine for government treasuries.
In the United States, the IRS generally defines cryptocurrency as property. Investors, therefore, are expected to pay tax on the difference between the price they paid for the crypto and the price they were paid when they sold it. The percentage varies, depending on whether the crypto was cashed out less than or more than a year later. In the former case, the crypto is considered a short-term gain, subject to marginal tax rates ranging from 10% to 37%. In the latter case, the crypto is considered a long-term gain, whose tax is capped at 20%.
If that sounds inequitable, that’s because it is. The tax rates encourage you to hold on to your cryptocurrency for more than the short run, and that’s not necessarily bad for the crypto community. That makes it economically inadvisable for new investors with very limited crypto experience to fall for “pump and dump” scams, which pop up without any warning at a moment’s notice and therefore require crypto liquidity. That’s assuming, of course, they report their gains in the first place.
Yes, Stashed Crypto Can Be Uncovered by Tax Authorities
Cryptocurrency and the relative ease with which it can be laundered on the blockchain are major draws for anyone who seeks to avoid discovery and/or taxes.
Of course, that happens to be illegal. Violators can and will be held accountable and may be punished to the full extent of the law. Ultimately, they will be forfeiting much more money due to fines and legal costs than they would have had they paid their taxes in the first place.
But how will the IRS be able to discover that you own crypto or have cashed it out over the past year? Isn’t crypto anonymous? It would be more accurate to describe it as pseudo-anonymous. That is because crypto can be traced through the blockchain to the exchange at which it is cashed out, where the relevant wallet owner can be identified. And with the right technology, which IRS auditors and the FBI have at their disposal, that’s easier than you might think. At MyChargeBack, we employ the same technology to track down the beneficiaries of crypto transactions made to fake investment companies, romance scammers, imposters, extortionists, and anyone else who has illegally obtained cryptocurrency from our clients.
How Will NFTs Be Taxed?
If cryptocurrency is property, what then is a non-fungible token, or NFT? The jury may still be out on that one, given that NFTs appeared on the digital firmament only this past year. Like crypto, NFTs are codes on the blockchain. Unlike digital coins on the blockchain, however, the ownership of each NFT on the blockchain—and thus the digital file it provides title to—is clearly marked and identifiable. That’s what makes them non-fungible, unlike crypto, which can be stolen, disguised, and laundered.
Most tax experts presume that NFTs will be considered for tax purposes as collectibles, like works of art, rare books, jewelry, and coin and stamp collections. There is good justification for that, considering that NFTs are digital files that are regularly sold as works of art. The most expensive of them thus far was a composition called “The Merge,” 266,445 “masses” of which were bought at auction by 28,983 individuals for $91.8 million in December of last year. Truth be told, “The Merge” resembles a collage rather than the Mona Lisa, and other NFTs sold for enormous amounts of money look like doodles or cartoons. Clearly, they’re not everyone’s cup of tea. But as they say, art is in the eyes of the beholder.
All that, of course, raises the possibility that NFTs may be something else as well. They might just be digital hedges.
Over the past year, the seemingly meteoric rise in the value of certain key cryptocurrencies stalled. Bitcoin broke the $60,000 barrier in October 2021. By the end of January 2022, it had fallen to less than $37,000. What can cunning bitcoin investors do to recover the losses they have suffered and buttress themselves from future downturns as well?
One answer is to buy NFTs, which can only be purchased with cryptocurrency. It’s no coincidence, therefore, that the NFT market exploded while bitcoin plunged. The only question is whether NFTs will hold their own in the artistic marketplace or whether their value will fluctuate in parallel with that of the crypto that was used to buy them. Sure, others who have gazillions to invest would probably prefer an original da Vinci. But as they say, necessity is the mother of invention. So if investors need a long-term hedge against crypto deflation, NFTs might become a free market of their own—at least until something else comes around. In the meanwhile, rather than cash out their crypto and pay taxes on their long-term gains, investors can keep the taxman waiting.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Michael B. Cohen is a co-founder and vice president of global operations at MyChargeBack. He is an expert in the field of complex dispute resolution.
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