Welcome. I am Olivier Wagner from 1040 Abroad and will provide an overview of taxation of cryptocurrency, Non-Fungible Tokens (NFTs), and Decentralized Finance

First disclaimer: While cryptocurrencies and NFTs have been gaining traction, these are an extremely volatile asset class.

Likewise, it’s an ever-changing environment, so please contact me before taking anything here as true as it may have changed.

Let’s start with a review of blockchain and the building block that lead us to where we are today.

We have building blocks:
– Blockchain
– Cryptocurrency
– Smart Contracts
– Tokens

Blockchain

The blockchain is a digital ledger. So if you could imagine a gigantic book.The blockchain is basically an automated decentralized book of transactions. It’s usually decentralized, but you can centralize a blockchain, although that would take away most of the benefits of having a blockchain.

Nobody wants a blockchain to be centralized. Everybody wants a blockchain to be decentralized.

The blockchain is a digital Ledger keeping track of transactions as they occur. A lot of people believe that the blockchain is a viable alternative to deeds for real property. Deeds are tracking from owner to owner every transaction involving the ownership of the real property itself.

The blockchain is the same thing. With the blockchain, if you want to track something, we can use this digital ledger to track it.

The blockchain is the bedrock of all of these digital assets that we will deal with today. The blockchain is what keeps track of cryptocurrency transactions. Likewise, for non-fungible token transactions, defi transactions.

The blockchain is a digital ledger that keeps track of all transactions regarding a given digital asset.

When you have cryptocurrency or NFT’s or anything else that you own digitally, you keep it in a wallet. The wallet has a public key, a public address, and a private key that is only known by you. The public key is your unique identifier.

This can theoretically remain anonymous because when The Ledger is populated, neither the sender nor the recipient names are in the blockchain. What’s in the blockchain is wallet addresses public keys. Nevertheless, someone collecting all the transactions might be able to infer the identity of the various owners.

The public keys are visible to everybody. Nobody knows who owns each public key unless somebody reveals it, which they would never want to do.

Nobody except for the owner has the private key. The public key is “Here’s my Bitcoin wallet public key and sends the Bitcoin to this address.” But to access the Bitcoin within that wallet, you need a private key. Only the owner has, and if your private key is compromised, you’re screwed because then a hacker or somebody else can gain access to the wallet itself. And it has happened…

To remedy that, there are two types of storage for those wallets:
Hot storage is when the wallet is connected to the internet, allowing transactions to occur live. Cold storage is when your wallet is disconnected from the internet and held on a local drive, which could take the form of a USB flash drive. That’s very secure except for the idea that heaven forbid you loose the USB flash drive.

Cryptocurrency

“A purely peer-to peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”
-Satoshi Nakamoto, Bitcoin White Paper, 2008

This is what Bitcoin was meant to be, and it was really the first cryptocurrency meant to be digital cash.

The white paper was meant to be like the mission statement of Bitcoin Satoshi Nakamoto is a pseudonym for somebody who anonymously created bitcoin or maybe a group of people anonymously created Bitcoin and called themselves Satoshi Nakamoto.

Satoshi Nakamoto wrote a Bitcoin white paper that said we could transact business over the Internet anonymously securely, and we could do it transparently through a decentralized ledger known as the blockchain.

The blockchain itself is extremely secure, but as discussed above, one can access a wallet if one obtains the private key. That was the case for Seth Green NFT Theft. And sadly, that was also the case for several exchanges which were hacked of cryptocurrency they were meant to safeguard.

Smart Contracts

Smart contracts are the foundation to decentralized finance smart contracts. Smart contracts basically say, they should really be called human-less contracts. Smart contracts are automated mechanism by which computers execute transactions with certain conditions have been fulfilled.

The contracts are not written in legal language. The contracts are written in computer code. If the conditions are met, it will execute the code.

If someone sends me 50 ether then I will send him my NFT. Right smart contract

He sends 50 ether and then automatically a bot literally sends my NFT out of my wallet.

A smart contract is just literally a computer-coated contract. Those are human-less contracts. These are contracts executed by computers.

When you have a smart contract, it really allows you to understand that a human being can’t toy around with whether that contract is going to be fulfilled.

In a smart contract, you have if then conditions that are executed by Bots.

You can have complete confidence that if you meet the if then condition, then the result is going to follow through because a computer is doing it. A computer can’t actually change its mind. So that’s why they call it smart contract.
It’s like a system where you don’t need to have the trust in the counterparty. It’s all done by Bots.

In decentralized finances, a lot of transactions are done by a smart contract.

The problem with smart contracts is that if you have a hacker that could put a really sophisticated smart contract together and then fool you into accepting it then they can still steal from you.

Smart contracts are automatically executable by the computer. The bot literally self-executes.

A vending machine is a type of smart contract – you put in a dollar, press the button to get the thing out of the vending machine that you want to drink; you put the dollar in, press the button, and you get it. This is all done by a computer program in the vending machine. It’s very simple, but that’s the way it works. Smart contracts are the same way. You put you okay, you put 50 ether into this Public public key wallet, and then you’re gonna get an NFT back.

These are supposed not to require any trust in human beings because the computers are doing everything right? Of course, there’s a command being given by a human being to set the whole chain in motion, but the computers are taking care of all of it.

Tokens

Tokens are transacted through smart contracts. Cryptocurrency could be the mean of exchange and the blockchain underpins all of it.
Two types of tokens are:
– fungible tokens
– Not fungible tokens

The difference between the two different tokens is:
If you have this Bitcoin or that Bitcoin, they’re still both worth one Bitcoin. It doesn’t matter which Bitcoin I have. Nobody cares which Bitcoin they get right.

So if I have 50 Bitcoin, I don’t care which of those Bitcoins you give me for my one NFT. If you just give it to me, I’ll give you the NFT. Every bitcoin’s worth the same.

Non-fungible Tokens However Are All Unique.

That would be the case with NFT’s. Each NFT you own is unique. There’s no other little jpeg like it in the world. There are differences between one NFT and another.

Both fungible and non-fungible tokens are exchanged either through smart contracts or through individual transactions between human beings.

The jpeg itself is not really the NFT. The NFT is really the token of ownership. It’s a certificate of authenticity saying yes, I own this ape.

A non-fungible token is you presenting it to somebody similarly to showing a certificate of ownership.

Taxation of cryptocurrency, Non-Fungible Tokens (NFTs) and Decentralized Finance

Let’s start with a purchase transaction. Let’s say I buy one ether.
I exchange fiat currency when I purchase one ether. Ether is treated as property. Back in 2014, the IRS came out with the revenue ruling that said: Cryptocurrency is property.

Ether is a property here. So when you purchase ether for a thousand dollars you have a basis in ether.

When I buy that ether on coinbase, I paid 1,000 dollars for one ether, I also paid fees of 40 to coinbase.

The cryptocurrency is treated as property for federal income tax purposes.

If you’re a dealer, the fee should be deductible from your basis.

You’re buying it for personal use or you’re buying it as an investment. The fees ought not to be deductible. And your basis would be a thousand dollars.

Buying it is not a taxable event. Buying ether itself is a purchase of an asset like anything else.

The purchase of it is not a taxable event, but that’ll be getting basis on that Ether. It will fluctuate in value. The value of ether will fluctuate with quite a bit of volatility. Now all those gains and losses are unrealized until you have a section 1001 disposition, a sale, or exchange. At that point, you will have a taxable event and tax owing.

When does that occur?
Let’s look at swapping different currencies. Let’s go ahead and say, I have this ether. It’s gone up in value now. We bought it for a thousand dollars, but the ether is now worth 1,220 and I want to swap ether for Dogecoin cryptocurrency.

These are two different cryptocurrencies. I got ether, and I want Dogecoin. I’m swapping ether for Dogecoin.

That is a section 1001 seller exchange.
It’s a seller exchange. So when I swap ether for Dogecoin I have a gain in my ether, right it’s the amount realized of 1,200. And then I subtract that from my adjusted basis, which is either a thousand dollars or 960, depending.

When you sell/exchange ether, it’s a taxable event. You will be deemed to have sold it at the fair market value of ether on that day, even if it was not sold for fiat currency.

The first concern is that you can’t pay your taxes with Dogecoin. As such, you need to ensure that you have enough US dollars set aside to pay the taxes that are associated with this transaction.

A lot of crypto people fail to understand this.

But cryptocurrency is all property. So when you swap property for property: that is a taxable event under section 1001.

If you do it on coinbase, you’re going to get a form 1099 from coinbase.

Next question, can we do a section 1031 exchange?
Unfortunately, that’s not possible as the tax cuts and jobs act restricted 1031 exchanges of January 1st of 2018 to real property only, so you can’t do 1031.

There are, however, tax proposals, bills, which would again extend the ability to do a section 1031 exchange to intangibles. However, the IRS has stated that even if those passed, they don’t regard cryptocurrencies to be like-kind to each other (as was the case for art: a painting and sculpture are not like-kind to each other)

Wrapping

Wrapping is the act of taking your token whether it is a cryptocurrency a fungible, token, or its digital artwork, which would be a non-fundable token.
Wrapping is taking that token and putting it in a blockchain environment where you have smart contract capability to do decentralized finance transactions.

Some cryptocurrencies such as Bitcoin don’t natively support wrapping.
You would need to warp it to do that. It’s like putting it in a box so that it is supported by that system.

For instance, you would wrap ether and take back raptoreum. So you give The Ether to the custodian and then the custodian gives you back raptoreum.

The question is: is that a section 1001 taxable event?

That doesn’t make any sense right on the surface if I go in and I give a custodian ether and then I get wrapped ether pack but a smart part of that smart contract. I also have the ability to give the custodian back my raptoreum and take back my original ether. So the transaction is totally revocable.

Cottage Savings Ass’n v Commissioner:

An exchange of property constitutes a “disposition of property” under §1001(a) only if the property exchanged is materially different.

Properties are materially different if their respective owners have legal rights of a different nature or scope. Even if the assets are economically “substantially identical” (1 ETH = 1 WETH), they may still be “materially different” for IRS purposes because they are not interchangeable in their use.

This means wrapping ETH may be a taxable event.

Purchasing NFTs

Now, if instead of wrapping, I bought a non-fungible asset, an NFT. Is it a taxable event? Yes. Likewise, it would be a section 1001 exchange.

Purchasing an unopened pack:

This is the same as buying basketball cards without knowing which ones they are. They can be very valuable, or they can be worthless.

The treatment is the same. Your basis is your total purchase price divided by the amount of NFTs you get in the pack. And if you get a valuable one, you don’t have a taxable event. You have an unrealized gain.

Airdrops & Forks

An airdrop happens when, by virtue of owning a digital asset, I can be given new digital assets as a perk of owning the other one.

Under Rev. Rul. 2019-24, the IRS clarified that they regard any airdrop and forks as income under the catch-all section 61 of the IRC.

“A taxpayer has gross income, ordinary in character, under § 61 as a result of an airdrop of a new cryptocurrency following a hard fork”
However, “A taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency”

The same can be said for both airdrops forks.

As per CCA 202114020 the FMV of received cryptocurrency can be determined using “any reasonable method”

Again, under under Rev. Rul. 2019-24, the IRS has determined that new coins received via an airdrop (or fork) are taxed as ordinary income. Therefore, you owe income taxes on the new coins you have in your wallet as a result of an airdrop (whether or not you want to own those coins).

Liquidity Pools

Liquidity pools happen when several investors get together to invest in cryptocurrency, and the issue here is that it can easily be regarded as a partnership, with the related reporting requirements.

When you put when you put a token into a liquidity pool, you take a different type of token out of it. That seems like a seller exchange whether it’s a partnership or not doesn’t change the outcome. It’s either a section 707 sale or it’s a section 1001 exchange.

Under code section § 761 “the term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate. Under regulations the Secretary may, at the election of all the members of an unincorporated organization, exclude such organization from the application of all or part of this subchapter, if it is availed of—
(1) for investment purposes only and not for the active conduct of a business,
(2) for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted, or
(3) by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities,
if the income of the members of the organization may be adequately determined without the computation of partnership taxable income.”

As we can see, IRC section 961 would define liquidity pools as partnerships, but it also gives the opportunity to opt out of such classification, provided that all partners take part in the election to opt out of partnsership status and that “the income of the members of the organization may be adequately determined without the computation of partnership taxable income”

Wash Sales

A wash sale occurs when an investor closes out a position at a loss and buys the same security within the 30-day wash sale period.
The IRS views this activity as creating artificial losses for tax breaks.

As you can see, an active trader can run afoul of the wash sales rule, thereby being prevented from deducting losses and still being required to pay tax on capital gains.

While the definition of wash sales under section 1091 relates to securities, and therefore it opens an interpretation under which cryptocurrencies would not be subject to wash sale rules.
I personally think that there’s a decent chance that even without legislation to correct this, which is already on the table, by the way, I think the IRS can come up with a regulation saying the word “security” in section 1091 includes all digital assets.

If that’s the case, it might be used to apply retroactively, so you should be careful.

Theoretically, you could perform wash sales without disallowing the losses, but I would really be careful.

LUNA became worthless

Can I claim a Section 165(e) theft loss?
Rev. Rul. 2009-9; Rev. Proc. 2009-20
Can we use the Ponzi scheme rules to amend and exclude income that resulted from trading LUNA in prior years?

Can we claim a Section 165(g) worthless security loss? No ; definition of “security” can’t include digital assets.

Voluntary Disclosure

While the IRS has a voluntary disclosure program and form 14457 as it relates to cryptocurrency and digital assets, if you live outside the US, I would still prefer and recommend the Streamlined Foreign Offshore procedure to get into compliance.

Have a question? Contact Oliver Wagner, 1040 Abroad.