Why cryptocurrency could be your worst tax nightmare

Bitcoin gains and losses are taxed like property, but a lack of information could make filing a challenge.

Feb 23, 2018 @ 4:43 pm

By Ryan W. Neal

Investors peppered wealth managers with questions about bitcoin throughout 2017 and the cryptocurrency soared in value and mainstream awareness.

While most professionals did not recommend buying the volatile asset, many clients took the plunge anyway and it could result in some tax headaches for advisers.

Bitcoin entered 2017 trading under $1,000 and surged to an all-time high of $19,783 on Dec. 17, according to Coindesk. Other popular cryptocurrencies like Ethereum and Ripple had bull runs of their own, meaning a lot of investors could be facing a lot of crypto-gains this year.

The IRS classifies bitcoin and other cryptocurrencies as property, meaning it's treated as a sale even if the cryptocurrency was used to make a purchase. Any increase or loss in value would be taxed as any other capital gain or loss.

The challenge is that many people don't closely track the spending and trading of cryptocurrencies, said Jamie Hopkins, an associate professor of taxation at the American College of Financial Services.

(More: Cryptocurrency frenzy poses a challenge to advisers)

Further, many of the cryptocurrency exchanges people use aren't providing taxable income forms for trades and transactions, leaving the burden on individuals to track losses and gains. The extreme fluctuations in value, the lack of consistency across exchanges, and individuals not understanding the impact of their own basis makes that task a challenge. "Digital currencies are all the rage today, but without proper planning they might just cause you rage come tax time," Mr. Hopkins said in an email. "Tax planning and tracking is really on the shoulders of individuals as the cryptocurrency exchanges are really not set up to help out with tax filings or tracking today."

Leon LaBrecque, managing partner at LJPR Financial Advisors, added that cryptocurrencies also are taxed as ordinary income if it was accepted for services rendered or if a client "mined" it. If the client mines cryptocurrency as a trade or business, they also have to pay self-employment taxes on it as well.

"Bitcoin is a nightmare for a variety of reasons, but taxes are one," Mr. LaBrecque said. "All in all, more tax hassles plus volatility."

Tim Steffen, director of advanced planning at Baird Private Wealth Management, said his firm does not sell cryptocurrencies nor make them available, but knows advisers are getting questions about them. But if advisers know about any crypto-gains, it's an opportunity to realize losses elsewhere in a client portfolio to offset the gain.

Advisers just need to be conscious of the holding period and the cost basis. And if a client is using bitcoin to purchase things, they need to check on which tax lots are used at the time of sale so they can manage the tax cost.

At the end of the day, Mr. Steffen said it's not too different from selling shares of a stock or mutual fund, just with less infrastructure in place. He said even if exchanges don't send tax forms to investors, their cryptocurrency transactions are still taxable events.

"Ignoring the law doesn't make you exempt from the law," Mr. Steffen said.

He doesn't think it will be a major issue this tax season, as most large firms and brokerages don't allow advisers to recommend cryptocurrencies. If an independent adviser is recommending it, he or she better should understand the tax implications.

"If you're going to be in this business, you should know what the rules are," he said.

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