Crypto Taxes: What’s at Stake When Staking?
The issue at stake (pun intended) is whether a gain or loss should be recognized when assets are staked in or staked out.
Updated FATF Guidance for VASPs and Others
Author: Olya Veramchuk, Director of Tax Solutions in Tax & Regulatory Affairs
FATF issues updated guidance for a risk-based approach for virtual assets and virtual asset service providers
The Financial Action Task Force (“FATF”), the global money laundering and terrorist financing watchdog, kicked off October 28, 2021, by issuing the updated guidance for virtual assets (“VAs”) and virtual asset service providers (“VASPs”). The earlier version of the report was issued in spring 2021 and was criticized by many industry participants for being too broad and unclear. The new iteration of the report forms part of the FATF’s ongoing monitoring of the virtual assets and VASP sector, offers long-awaited clarifications and comments on DeFi protocols, NFTs, stable coins, travel rule application, and more.
For better or worse, the document is long and FATF intends for the definitions to be applied broadly. High-level highlights of the new guidance are outlined below.
- VAs are defined as “a digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes. Virtual assets do not include digital representations of fiat currencies, securities, and other financial assets that are already covered elsewhere in the FATF Recommendations.”
Notably, non-fungible token (“NFT”) collectibles weren’t explicitly included in the definition of virtual assets. However, in the event an NFT is used for “payment, investment purposes” or as a value transfer, then it would likely fall under the VA umbrella. FATF suggests that the regulators apply a “functional equivalence and objective-based approach” when in doubt, encouraging understanding assets’ functionality and purpose.
Further, FATF lowered the threshold amount for VA-related transactions to USD/EUR 1,000 due to the money laundering risks “associated with, and cross-border nature of” virtual asset activities.
- VASPs are redefined to ”any natural or legal person that conducts one or more of the following activities or operations for or on behalf of another natural or legal person:
- Exchange between virtual assets and fiat currencies;
- Exchange between one or more forms of virtual assets;
- Transfer of virtual assets;
- Safekeeping and/or administration of virtual assets or instruments enabling control over virtual assets; and
- Participation in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset.
Depending on their particular financial activities, VASPs include “VA exchanges and transfer services; some VA wallet providers, such as those that host wallets or maintain custody or control over another natural or legal person’s VAs, wallet(s), and/or private key(s); providers of financial services relating to the issuance, offer, or sale of a VA (such as in an ICO); and other possible business models”.
Interestingly, multi-signature wallets where “a person maintains unilateral control of their assets at all times” seem to not be covered by the VASP umbrella. But only as long as it doesn’t “actively facilitate” the transfer. Unfortunately, no explanation as to what “active facilitation” would mean was provided.
- No concrete clarification is provided with respect to DeFi protocols. The guidance introduces the concept of owner vs. operator and remarks that anyone with “sufficient influence” of a protocol would rise to the level of a VASP. It is unclear how one would define how much influence would rise to the level of being “sufficient” or how that should be measured.
- Stablecoin issuers with a “central developer or a governance body” which handles the basic management functions, including “development and launch of” a stablecoin, would likely be classified as financial institutions or VASPs.
- FATF is particularly concerned with the peer-to-peer transactions carried out via self-hosted and unhosted wallets, as in their view such transactions pose a heightened risk of money laundering. This is because “illicit actors can exploit the lack of an obligated intermediary in P2P transactions to obscure the proceeds of crime because there is no obliged entity carrying out the core functions of the FATF Standards.” Risks could be mitigated in the following ways:
- Conducting outreach to the private sector;
- Training of supervisory, financial intelligence unit and law enforcement personnel; and
- Encouraging the development of methodologies and tools, such as blockchain analytics, to collect and assess P2P market metrics and risk mitigation solutions, risk methodologies to identify suspicious behaviour, and determine whether wallets are hosted or unhosted, including by engaging with programmers/developers in this space.
- The travel rule requirements were expanded: VASPs are now expected to ensure disclosing and transferring certain customer data as part of each digital asset transaction, but robust due diligence with respect to the counterparty VASP is required before the information is remitted. This is because VASPs which do not implement the travel rule would be considered higher risk. Transactions should be screened on the ongoing basis to ensure that no sanctions were levied on the counterparty to the transaction. Notably, FATF clarified that the travel rule would not apply to transfers between a VASP and an unhosted wallet, thus taking the fees paid to validators and miners out of scope.
It is worth remembering that FATF guidance is not binding and does not override the views of the national authorities. However, the organization has its ways of applying pressure on non-compliant members, including blacklisting them. Undoubtedly, the next few weeks will be extremely interesting, as the guidance gets dissected and digested by global regulators and market participants alike.
The information contained in this bulletin provides only a general overview of current issues and shall in no event be construed as the rendering of professional advice or services. As such, the information provided in this bulletin should not be used as a substitute for consultation with professional advisors. Before making any decision or taking any action regarding your digital currencies or the tax treatment thereof, you should always consult with an appropriate, licensed tax, accounting, or other professional. To the fullest extent permitted by law, in no event will Lukka, Inc. (including its related entities, owners, agents, directors, officers, advisors, or employees) be liable to any reader of this bulletin or anyone else for any direct, indirect or consequential loss or loss of profit arising from the use of this bulletin, its contents, its omissions, reliance on the information contained within it, or on opinions communicated in relation thereto or otherwise arising in connection therewith.
Wash Sales, Constructive Sales and Cryptocurrency
Updated April 2022
Author: Olya Veramchuk, Director of Tax Solutions in Tax & Regulatory Affairs
Ways and Means summary report published yesterday proposed including digital assets into two provisions – wash sales and constructive sales.
Wash sale rules under Section 1091 defer loss recognition in instances where an investor trades a security at a loss, and within 30 days before or after buys a substantially similar security. Instead, the realized loss is added to the cost basis of the new security, thus reducing future capital gains on disposition. Since cryptocurrency and other digital assets are treated as property and not as securities, they are not caught by Section 1091 provisions currently, effectively permitting taxpayers to claim tax losses while retaining an interest in the loss asset.
Constructive sales under Section 1259, also known as “shorting against the box”, prevent an investor from locking in investment gains without paying capital gains tax and require gain recognition with respect to hedged positions. Similarly, because constructive sales rules historically applied to stock, debt, and partnership interest, none of which include crypto assets under the current rules, savvy crypto investors were able to take advantage of the loophole.
If adopted, the rules outlined above would apply to transactions occurring after December 31, 2021.
Non-Forgiving Taxes for NFTs
Updated April 2022
Author: Olya Veramchuk, Director of Tax Solutions in Tax & Regulatory Affairs
Not long ago, most people would have needed to Google what a non-fungible token (“NFT”) was. Generally, it is a digital representation of certain rights associated with an asset or experience that exists on a blockchain.
Today, not a week goes by without an announcement about new NFTs being launched by artists, athletes, New York Times columnists, and anyone in between, or NFTs selling for large amounts of money on a secondary market. Some of the latest examples are Visa’s purchase of a CryptoPunk for $150,000 and a 12-year old coder making $400,000 on sales of pixelated whales.
This is not entirely surprising, given that collecting things is part of human nature, and the timing for virtual collectibles seems particularly appropriate after a year and a half of virtual working environments being the norm. Many skeptics speculate that NFTs are yet another bubble that will inevitably burst. Others maintain that practical NFT use cases are limitless and will far surpass the current frenzy over Ethereum rocks, CryptoPunks and Pudgy Penguins.
Whatever side of the spectrum one may be on, it is essential to understand the tax issues that come along with all life stages of an NFT. This is particularly important for NFT creators, who should consider whether minting NFTs is their business or just a hobby, understand intangible property rules, satisfy reporting obligations, and face state and local tax issues. NFT buyers need to remember that not only selling but also buying an NFT is a taxable transaction. This is because NFTs are purchased with cryptocurrency, mainly ETH, and therefore each transaction is viewed by the Internal Revenue Service (“IRS”) as a property-for-property exchange, as discussed in more detail below. NFT traders should also consider how the income earned should be characterized depending on their activities. Although the IRS has yet to issue any digital asset-specific guidance, let alone NFT-specific guidance, existing rules could be applied to analyze tax implications from the perspective of different market participants.
Tax Considerations for NFT Creators
While creating an NFT does not bear tax consequences in and of itself, it is vital to differentiate between doing it as a hobby or as a trade or business. This is because someone minting NFTs for a living would be able to deduct or capitalize and amortize costs (e.g., materials, gas fees, etc.) incurred in the process. They may also be eligible for the qualified business income deduction. However, any income realized on a disposition of an NFT would be subject to self-employment tax, in addition to the regular business income tax. By contrast, someone minting NFTs as a hobby would not be able to deduct expenses or take advantage of other potentially available deductions, but they would not be liable for self-employment tax, either. Whether someone is in a trade or business of minting NFTs or doing it as a hobby, any realized income would have ordinary character.
As mentioned above, an NFT is a digital certificate of certain rights associated with an asset. Therefore, when a creator sells an NFT, it is important to understand whether they have transferred all of the rights for a given NFT or just some limited rights (i.e., have retained the copyrights). The first instance would be treated as a sale for tax purposes. The creator’s realized ordinary income would be offset with the basis in the NFT, subject to certain limitations. If only limited rights are transferred, the transaction would be treated as a licensing agreement, entitling the creator to royalty income, including any from future sales of the NFT on the secondary market. Technically, if royalties are paid to a foreign person, they may be subject to withholding taxes, and the payor (i.e., the current NFT holder) would be the party liable for withholding the tax and transmitting it to the IRS. However, it is not very clear at the moment how this could be executed in practice, given the decentralized nature of digital assets and the inherent lack of visibility to the transaction counterparty.
Tax Considerations for NFT Investors
Despite the lack of guidance from the IRS, many industry participants treat NFTs as capital assets, the disposition of which would generate short or long-term capital gains and losses, depending on the holding period of the NFT. Still, it is important to remember that because NFTs are acquired with cryptocurrency, which the IRS declared to be property, then for tax purposes, each NFT acquisition and disposition is a taxable event since it is considered to be a property for property exchange. The buyer would need to know the basis and the holding period of the cryptocurrency used to buy an NFT to calculate the tax liability on the purchase leg of the transaction. When the buyer decides to dispose of the NFT, they need to compare their basis in the NFT to the market price of the cryptocurrency they accepted as a payment for the NFT. In both cases, the holding period would dictate whether the gains or losses should be short-term (for assets held under a year) or long-term (for assets held over a year). In addition, realized gains may be subject to the Net Investment Income Tax (“NIIT”) of 3.8%. NIIT is levied on investment income, which includes, among other things, capital gains. However, this tax is generally relevant to high-income earners because it would only apply in instances where a taxpayer’s modified adjusted gross income goes over a certain threshold.
There is a nuance for the NFT buyers who are digital art dealers by trade. Because they are in a trade or business of buying and selling NFTs, the assets they hold would be treated as inventories, and any realized gains or losses would be of ordinary character.
In addition, current tax law considers works of art, among other things, as collectible items. Such assets are subject to a special collectibles long-term capital gains rate, which is higher than the general capital gains rate. Many industry participants believe that some NFTs could be considered works of art and should be treated as collectible items. Again, regardless of the classification, where an NFT is held for less than a year, a regular short-term capital gains rate would apply.
Lastly, NFTs are generally purchased with hopes of appreciation, unless, of course, someone really believes in a particular project or admires a particular artist. But not every launch is successful, and not every asset goes up in value, with some NFTs becoming worthless. Taxpayers may be able to take a worthless deduction on their returns, assuming they are able to prove that the asset is truly worthless.
State and Local Tax Considerations for NFTs
All of the tax issues discussed above are covered by the federal tax umbrella. However, individual states also want their share of the pie – and that’s where things get even more complicated. If the federal government is struggling with putting forward meaningful guidance for digital assets, then state and local tax authorities are struggling even more. Moreover, any limited guidance issued by a particular state is likely rendered useless in another state due to the differences in state and local tax laws.
Some states impose income taxes. Generally, such states follow federal tax principles to compute taxable income. Resident individuals then get taxed on all of their taxable income. Nonresident individuals and corporations get taxed on taxable income sourced to the state. Some states impose sales and use taxes. Sales tax is typically imposed by the jurisdiction where a sale has occurred, and use tax is charged where the good or service is consumed. Levying such taxes on tangible personal property and services is much easier than on digital assets – again, due to the fundamental differences between digital assets and tangible property.
Therefore, those in a trade or business of selling NFTs would likely need to go through a challenging exercise of determining the source of income related to their NFT activities and then appropriately apportion it to the relevant states or establish where they would be subject to sales and use taxes. As discussed earlier, absent any guidance from the tax authorities, solving a sourcing puzzle in the context of decentralized digital assets transactions would quite possibly prove to be futile. Luckily, Lukka has a variety of resources to help you in your crypto education. Lukka Library is a content database filled with articles, educational resources, and position papers from some of the industry’s foremost thought leaders on crypto tax, regulation, and many other subjects. If you’re looking for a software solution to help you manage your crypto assets, including NFTs, Lukka can help with infrastructure specifically designed for the intricacies of blockchain and crypto data. LukkaTax for Professionals is a crypto tax software for CPAs and tax professionals that need to assist their clients with filing crypto taxes, and Lukka Essentials allows individuals to manage their crypto portfolio and calculate crypto taxes.
The Senate’s Approval Of the Infrastructure Bill and Its Effect on Cryptocurrency
Author: Olya Veramchuck, Director Tax Solutions in Tax & Regulatory Affairs at Lukka
On Tuesday, August 10th, the Senate approved the much-debated Infrastructure Bill, a cornerstone of President Joe Biden’s agenda. The bill is estimated to raise $28 billion from digital asset investors by applying new information reporting requirements on participants in the digital asset industry.
Current Guidance with Section 6045
Generally, under Section 6045 rules, those falling under the definition of a “broker” are required to issue Form 1099 to report gross proceeds on a transaction-by-transaction basis together with their customers’ names, social security numbers, and other relevant information. The language of the bill expanded the definition of a broker to include “any person… effectuating transfers of digital assets, including any decentralized exchange or peer-to-peer marketplace.”
This development has a significant impact on many participants of the digital asset ecosystem, particularly within DeFi, and would likely put a strain on the entire industry.
Section 6045’s Reporting Requirements
Complying with Section 6045 information reporting requirements may not prove possible for many as they have no visibility to the parties sending or receiving digital assets. The approved bill’s language has an extensive net covering miners, services that stake digital assets, node operators, validators, smart contracts, open source developers, hardware and software wallet manufacturers, DAO token holders, and others. This also touches individual investors who are either:
- Buying or selling crypto from other individuals
- Trading crypto for crypto through a crypto exchange (or equivalent) as crypto/crypto trades are simply two transfers occurring at the same time that a broker or dealer facilitates, most often through the use of technology or through a DEX, where there may not be an institution and only technology facilitating exchange between individuals
This would effectively require affected individuals to report at the level of institutions. Transactional reporting is easily done by traditional financial institutions , where it is clear who the broker is (for example, an intermediary like Vanguard) and who the customers are (for example, investors in Vanguard mutual funds).
The issue was recognized by a number of Senators, including Senators Wyden, Toomey, and Lummis, who advocated revising the language to exclude miners, hardware and software wallets providers, and limit the reporting obligations to the parties who can actually report (for example, crypto exchanges).
However, the narrowed scope was determined to reduce the projected revenue by approximately $5.17 billion. Despite Senator Portman tweeting that an agreement was reached on “an amendment to clarify IRS reporting rules for crypto transactions without curbing innovation or imposing information reporting requirements on stakers, miners, or other non-brokers,” the language remained in the originally proposed form.
The passing of the bill without narrowing down the definition of a broker may potentially result in the outflow of talent and innovation overseas as venues owned and administered by foreign persons are out of reach of US reporting rules. This could materially limit the economic benefits of the digital assets industry in the United States compared to the global economy.
Because the Treasury and the IRS are yet to issue any formal guidance on the taxation of digital assets, it is not unreasonable to expect at least 18-24 months of preparation time before the new rules come into effect. Currently, the law is expected to be implemented in 2023.