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Estate Planning Update – 08.17.21
Tax and Estate Planning for Cryptocurrency
By: David Hunter & Nick Nester
In the past year, the global market capitalization of cryptocurrency has grown exponentially, reaching a high of $2.56 trillion on May 11, 2021. Coinbase, the largest cryptocurrency exchange, has more than 68 million verified users. By comparison, TD Ameritrade has 11 million accounts, Charles Schwab has 14.1 million accounts, and Fidelity has 83.4 million accounts.
Although opinions on cryptocurrency differ, this massive gain has led to some investment experts recognizing cryptocurrency as a legitimate asset class. Warren Buffett has referred to Bitcoin (the most significant cryptocurrency) as “rat poison squared.” Suze Orman has said cryptocurrency should be part of your investment portfolio as long as you can afford to lose that money and you are going to keep it for a reasonably long time.
In recent months, there has been a wide-scale acceptance of cryptocurrency among large financial institutions, including Fidelity, Goldman Sachs, and Morgan Stanley. In addition, PayPal now allows users to make transactions in cryptocurrency.
Although cryptocurrency is gaining steam within the financial industry, many still see it as a valueless asset. Whether you are bullish on cryptocurrency or think it is a fad — there is no denying that cryptocurrency has become more mainstream, and consideration should be given to estate and tax consequences.
Income Tax Treatment
In IRS Notice 2014-21, the IRS took the position that cryptocurrency is property and should be taxed as such. This position has not changed. Accordingly, a taxable event has occurred whenever one disposes of cryptocurrency, whether for a good, service, another coin, or fiat currency (e.g., U.S. dollar). That is, the taxpayer disposing of cryptocurrency will generally have either a capital gain or loss on the transaction.
Much like other types of property, capital gains and losses apply to cryptocurrency; however, the biggest benefit to the tax treatment of cryptocurrency is that the wash-sale rules arguably do not apply. While the IRS has not officially taken a position on this treatment, many commentators have interpreted the IRS’ silence as such. As a result, they effectively allow a taxpayer to harvest losses and eliminate a portion of the taxpayer’s gains.
Cryptocurrency is a highly volatile asset. Charitable remainder trusts, such as a charitable remainder unitrust (CRUT), may be used by taxpayers holding highly appreciated cryptocurrency to address cryptocurrency volatility, spread the income tax hit from the sale of cryptocurrency over a number of years, and possibly receive a charitable income tax deduction. A CRUT is a trust designed to pay the grantor a payment based on a fixed percentage of the trust value yearly for a term of years or the lifetime of the CRUT beneficiary. CRUTs allow a taxpayer to receive an immediate charitable deduction upon their transfer of cryptocurrency into the CRUT. The CRUT can then sell the cryptocurrency and reinvest in a more stable asset, such as stocks, bonds, mutual funds, etc. A CRUT does not pay income tax, but the beneficiary will only on the distributed income. Upon termination of the CRUT, the balance of the CRUT assets are paid out to charity. In effect, a CRUT allows a taxpayer to stretch out a capital gain tax hit over several years.
Tax Compliance
The United States government has recently taken a strong interest in tax compliance as it relates to cryptocurrency. In fact, the infrastructure bill recently passed in the Senate contemplates financing a large portion of the bill’s cost with increased compliance on crypto tax issues.
Cryptocurrency is significantly underreported to the IRS. The laws are new, and many who operate in this space do not realize that the transactions are taxable. Even if every individual who had a taxable cryptocurrency transaction wanted to report such transaction, the reporting documents issued by the popular cryptocurrency exchanges are not user-friendly. To increase compliance with proper reporting of cryptocurrency, a higher audit rate will likely follow.
Please click Read More for more information on cryptocurrency and how it relates to estate planning and gifting.
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