Talking to Your Clients About Crypto Taxes: A Guide for Financial Advisors

Cryptocurrencies, like other investments, are taxed. However, understanding cryptocurrency tax rules can be more complicated than for other types of assets.

Due to cryptocurrency’s newness, many investors are unsure how to handle taxes on it. Some might not even know they need to report taxes on it. Tax laws are frequently updated to match the latest tech changes.

Having knowledgeable conversations can help investors better understand tax rules. Here’s how financial advisors can prepare to discuss crypto taxes with clients.

Download: Are your clients interested in crypto? Use this discussion guide.

Understanding Cryptocurrency Taxes

In the United States, cryptocurrencies are considered property and are taxed similarly to investment income, regular income, gifts, or donations by state and federal governments. Tax laws may differ by state and territory but are consistent for individuals, corporations, and funds at the federal level.

Cryptocurrency includes assets like Bitcoin, Ethereum, NFTs, and DeFi products. The IRS is the federal tax authority in charge of taxes across the United States.

• Investment income: When you make money by buying and selling cryptocurrency, it’s like earning income from an investment. If you sell the cryptocurrency within a year of buying it, you’ll pay taxes on the profits at your regular income tax rate. If you hold onto it for more than a year before selling, it’s taxed differently, similar to how profits from selling stocks are taxed.

• Ordinary income: When you get cryptocurrency as payment or passive income, like from interest accounts, a job, staking, mining, or an airdrop, it’s seen as regular income, not investment income.

• Gift: Cryptocurrency is seen as a gift if it was given for free and wasn’t a payment, loan, or interest.

• Donation: Donations made with cryptocurrency can be deducted from taxes by the donors. However, recipients may owe gift taxes.

For federal taxes, long-term capital gains are taxed based on income, with rates increasing as income rises, but there’s a maximum percentage. Short-term capital gains and ordinary income are taxed at the same rate as the tax bracket for an individual’s, business’s, or investment fund’s annual income.

Tax-registered entities, like corporations, nonprofits, and limited partnerships, have varying tax rates. This includes differences between S corporations (S corps), limited liability companies (LLCs), and other corporate structures. If crypto was received as a wage, ordinary income might include self-employment taxes.

Gifts below a certain value don’t have federal tax consequences and don’t require reporting to the IRS. Once they exceed that limit, gift taxes come into play and increase depending on their taxable value, up to 40%. Virtual currency received as a gift isn’t treated as income until sold, exchanged, or otherwise used.

Donations made in cryptocurrency can be subtracted from gross income to reduce taxable income, similar to standard and itemized tax deductions.

Some investors may not know they must file quarterly estimated taxes if they anticipate owing more than $1,000 in cryptocurrency taxes on their yearly federal tax return.

Discussing Crypto Taxes With Clients

Talking to clients about cryptocurrency taxes is crucial for reducing their tax burdens for financial planning and avoiding possible penalties from tax authorities.

General Points

Not filing tax returns and paying the right taxes can lead to lengthy audits and heavy fines from financial regulators. Investors might save on taxes by moving to different states, trading certain amounts, or using reference prices that lower capital gains taxes.

The IRS and some states include questions about cryptocurrencies on tax forms and have teams dedicated to checking for unreported taxes. Major crypto exchanges such as Coinbase, Kraken, and Gemini share data on customers who earn above a certain amount of cryptocurrency income in a taxable year. Companies like Chainalysis, Elliptic, and TRM Labs are also hired to track unreported transactions and match them with known identities.

State and Federal Tax Overview

Some states or territories don’t have income taxes or capital gains taxes. Others may not collect personal taxes but impose corporate taxes and might provide beneficial tax breaks and incentives for digital assets.

At the federal level, cryptocurrencies sold after holding for more than a year are taxed at long-term capital gains rates. Short-term capital gains are taxed at the same rate as regular income. Additionally, every trade is subject to taxation regardless of the transaction size, whether converting crypto to fiat currency or swapping between different tokens.

The Topic of Cost Basis

When investment income is considered, or a crypto transaction effectively becomes a trade, taxes on crypto holdings are calculated using a cost basis.

If the sale price of an asset, minus transaction fees, commissions, and acquisition costs, is lower than the purchase price, including these expenses, it results in a capital loss. On the other hand, if the sale price exceeds the purchase price after deducting these expenses, it results in a capital gain.

So, in certain situations:

• Active traders may have higher federal tax obligations compared to passive investors.

• Customers in higher federal income tax brackets might owe lower taxes on cryptocurrency held for more than 12 months.

• Investors participating in crypto tax-loss harvesting and selling during market downturns could report capital losses instead of capital gains to reduce their tax obligations.

• People living in specific states or territories might have minimal tax obligations on cryptocurrency transactions, which benefits investors who frequently buy and sell crypto.

Preparing for the Crypto Taxes Conversation

Understand the Advice You Can Offer

Understanding the difference between tax planning and tax advice is crucial. Financial advisors not licensed to prepare tax returns can assist clients with tax planning. They can suggest setting aside funds to cover taxes or informing clients about their expected tax rates.

However, it’s best to avoid providing direct, detailed tax advice. Tax advisors, licensed to prepare tax returns, can offer more specific guidance on which tax forms clients must file or what they must report.

If a financial advisor provides tax advice without the proper licenses or permissions and gives a client incorrect advice, it could expose them and their firm to legal risks.

So, when discussing crypto or any taxes with clients, remember what kind of advice or information you can give and what should be left to tax professionals. I suggest that clients consult with a tax advisor for detailed tax advice.

Gather Information

To get ready for your chat with a client, know which cryptocurrencies they’ve had and how they’ve used them. Without this info, you can’t determine how much they owe in taxes or if they’re taxed, like investment income, regular income, gifts, or donations.

Explain to clients that if they’re working with a tax advisor, they’ll need to gather records that show:

• The specific dates, times, and prices of when the crypto assets were received, purchased, or sold.

• Where did they acquire the crypto, or how did they obtain it?

• What transaction fees, commissions, and acquisition costs were applied (which will impact the cost basis of their returns)?

You can typically download these records from the cryptocurrency exchange or platform where the trades or transfers occur.

Unlike financial advisors, tax advisors are responsible for determining which tax forms clients must file, including those specific to their state or territory of residence. Taxes vary by location, so confirming the residency status and using the appropriate forms is essential. Federal tax forms are the same nationwide, regardless of state or territory.

Review Financial Objectives

Consider your client’s financial goals and circumstances regarding their crypto assets that are still held and not yet sold. Your advice may vary depending on potential relocation or short-term liquidity needs. Some clients may need to sell their crypto soon to access cash, while others may be able to hold onto their investments for longer periods. Understanding their specific situation will help you tailor your recommendations accordingly.

Basic Calculations for Crypto Taxes

Cryptocurrency owners in the U.S. must grasp certain mathematical formulas and ideas to determine cryptocurrency taxes. These include understanding cost basis, sale price, capital gains, and losses.

Cost Basis

The cost basis is the original amount paid to purchase a token or the value it was received for (price multiplied by the number of units), plus any additional entry and acquisition costs, like transaction and commission fees.

The cost basis is crucial for determining the worth of crypto assets for tax purposes, whether it’s considered investment income, non-investment income, gifts, or donations. Crypto investors often have different cost bases because of the market’s ups and downs and changing transaction fees.

Sale Price

The sale price is the total amount received when selling a token for cash or exchanging it for another cryptocurrency. It’s calculated by multiplying the price by the number of units and then subtracting any fees associated with the transaction.

The sale price is important for calculating capital gains or losses when determining taxes on cryptocurrency treated as investment income.

Capital Gains and Losses

Capital gains or losses are relevant for cryptocurrencies involved in discretionary trades, taxed as investment income. This applies when crypto is bought and sold for cash or exchanged for different assets.

The capital gain or loss is the difference between a traded position’s sale price and the cost basis. It’s also known as the return on investment (ROI).

Communicating Complex Concepts

Taxation can be complex, so you or your clients’ tax advisors must explain it clearly. This helps crypto investors understand the issues without asking the same questions repeatedly, allowing them to make decisions that benefit them in the long run.

Start with simple steps to establish a foundation. Educate clients about basic concepts first, then progress to more advanced topics, or recommend they consult with their tax advisor.

Start With Some Essentials

Using hypothetical numbers as examples is a helpful way to explain tax concepts. For instance, you could say, “If someone bought $10,000 in Bitcoin and sold it for $15,000, they would need to pay taxes on the $5,000 profit.” This helps clients understand how capital gains work.

Afterward, the examples can be adjusted to fit the client’s tax circumstances. Numbers can be changed to match their specific crypto holdings. Visual aids like drawing boards, educational videos, and tax calculators can be used to illustrate calculations.

Clients may feel overwhelmed by tax forms and require a tax expert to simplify them. Going through the tax forms systematically and following the instructions provided by the state, territory, or federal tax agency could help clear up any confusion clients may have when completing them.

More complex scenarios that require visual teaching aids will likely include explaining how to calculate capital gains or losses for various crypto assets and tax categories, like investment and ordinary income.

Here are some examples to help explain some of these advanced ideas:

Multiple Tax Distinctions

“Gifting $1,000 worth of Bitcoin and converting it into $2,000 worth of Ether after holding for 12 months could result in a taxable capital gain of $1,000. However, exchanging it before the 12-month mark would mean it’s taxed as ordinary income. Understand the tax implications before making any crypto transactions.”

Multiple Crypto Assets

“It’s important for cryptocurrency users to keep track of all their transactions in a log. This helps them or their tax advisor determine how each transaction will be taxed. For example, let’s say you bought some cryptocurrency at a certain price and then sold it later. You can determine the tax implications by keeping a record of these transactions. Remember to include details like purchase and sale prices in your log to calculate taxes accurately.”

• “Investor purchased $10 worth of bitcoin on March 13, 2022.”

• “The following day, they traded the bitcoin for $13 worth of ether.”

• “One year later, on March 14, 2023, they exchanged the ether for $14 worth of Litecoin.”

• “The next day, on March 15, 2023, they sold the Litecoin for $15 and received cash.”

Here’s how the tax events would appear:

• Converting Bitcoin to Ether in 2022 would generate $3 of regular income.

• Swapping Ether for Litecoin in 2023 would generate $1 in capital gains.

• Exchanging Litecoin for cash in 2023 would lead to $1 in regular income.

The investor must include $3 as regular income from cryptocurrency on their 2022 tax return. For their 2023 tax return, they should report $1 as capital gains and $1 as regular income from cryptocurrency transactions.

Addressing Common Client Questions

Being prepared to answer common questions about cryptocurrency taxes can ease clients’ concerns. Researching ahead of time helps identify frequently mentioned issues. As a financial advisor, offering clear explanations can quickly address clients’ questions and provide reassurance.

Here are some common questions people often have about taxes on cryptocurrency:

How Much Will I Owe in Taxes on My Cryptocurrency Holdings?

Clients often want financial advisors to outline their tax responsibilities based on potential scenarios. Although precise figures aren’t required, offering estimated tax rates can offer clients a broad understanding.

Are Taxes Calculated Differently for Each Cryptocurrency Asset?

Cryptocurrencies are taxed based on how they were obtained, how long they’re kept, and how they’re utilized—not their names. For instance, one crypto asset, such as bitcoin or ether, might be taxed differently if acquired differently. However, whether popular or niche, multiple crypto assets could be taxed similarly if obtained from similar sources.

The tax rate depends on where the cryptocurrency came from at a particular time. Taxes are calculated separately for each source and then added up to find the total tax owed. Sources can include exchanges, mining, staking, interest, airdrops, and transactions with family and friends.

How Can I Reduce the Cryptocurrency Taxes I Owe?

Clients seek ways to reduce costs in their daily expenses, spending habits, and tax obligations. Familiarity with various tax codes, investment options, and financial calculations enables you to explain the best tax-saving strategies and avoid overlooking potential savings options.

Providing Tax Planning and Compliance Services

Financial advisors offer general advice, tips, and guidance to enhance overall financial well-being from a holistic perspective. However, they are not responsible for performing detailed accounting, filing taxes for clients, predicting every tax-saving opportunity, or providing legal counsel on tax matters.

Effective financial planning involves some level of mathematics. For instance, one might calculate the breakeven point to compare the cost-effectiveness of tax savings and brokerage fees in a crypto IRA versus the tax expenses and transaction fees of trading crypto on an exchange.

Refer Clients to Appropriate Professionals

Tax calculations and projections require thorough examination and validation by a certified tax professional. Financial advisors can recommend clients to licensed accountants, actuaries, auditors, and lawyers to determine accurate numbers and ensure legal compliance.

Heavy cryptocurrency investors may find hiring an accountant to handle their tax filings beneficial. Hiring an auditor could also be practical if the investments are for a business or a fund.

As a financial advisor, it’s important to understand your client’s needs while fulfilling your general responsibilities. Your role provides a solid foundation and gateway for exploring more advanced financial planning concepts.

Resources for Further Information

As cryptocurrency is still new and its regulation is changing, it’s crucial to stay updated on how it’s taxed to help clients who invest in it.

Contact agencies like the IRS and state tax departments for current tax information. They offer FAQ pages and websites detailing digital asset tax accounting and related publications.

Big cryptocurrency exchanges and crypto news websites often publish blog posts and articles about cryptocurrency taxation, covering recent updates and materials. However, for the most accurate and comprehensive information, it’s best to go directly to the source: tax regulators and other regulatory bodies.

FAQs

The Bottom Line

Cryptocurrencies are taxed in many ways, offering different opportunities for tax savings. Financial advisors can provide general guidance, while tax advisors can offer specific, expert advice tailored to individual clients.

As a financial advisor, it’s important to know the extent of advice you can give clients regarding cryptocurrency taxes. Be ready to suggest they speak with a tax or other professional when needed.

The comments, opinions, and analyses on Investopedia are provided for informational purposes online. For further information, refer to our warranty and liability disclaimer.

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