Executive summary: Cryptocurrency terminology updated
In recently released drafts of next year’s Form 1040 and instructions, the IRS changed the term “virtual currency” to “digital asset,” signaling the agency’s growing enforcement efforts toward evolving digital assets, including non-fungible tokens (NFTs). The tax return instructions continue to provide examples of when taxpayers should check the “Yes” box in response to the question of whether they engaged in digital asset activity.
IRS inclusive term of digital assets
The IRS changed the term “virtual currency” to “digital asset” in a draft of the Form 1040 instructions it released on Oct. 17, 2022. This follows a similar change made on a draft Form 1040 for 2022 released by the IRS in September. This change continues to signal the agency’s growing enforcement efforts toward all forms of digital assets, including non-fungible tokens (NFTs). Indeed, for the first time, the IRS instructions specifically mention NFTs.
A virtual currency question first appeared on Form 1040 (Schedule 1) in 2019. Since then, the IRS has moved this question to the first page of the Form 1040 and slightly modified it every year. Aside from these annual updates, the IRS has released very little formal guidance about the tax treatment of digital assets. Experienced practitioners in this field will not be surprised by this year’s tax form change since virtual currency is also a form of a digital asset. The IRS previously stated that regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as such for federal income tax purposes.
While IRS forms and instructions are helpful to understanding the law and often signal key IRS enforcement priorities, they do not have the effect of law. One unanswered question involves the receipt of new digital assets as a result of mining, staking and similar activities. The instructions are clear that a taxpayer engaging in staking activity should check “Yes” to this question. However, there is currently a debate about whether the mere receipt of assets from staking activity needs to be reported anywhere else on the tax return.
In a lawsuit filed in the U.S. District Court for the Middle District of Tennessee, a taxpayer claimed that his receipt of staking reward assets was not taxable income and sued for a refund (Jarrett v. United States, Case. No. 3:21-cv-00419). Instead of defending the lawsuit, the Department of Justice authorized a refund to the taxpayer and mooted the case.
Taxpayers with significant digital asset activity should continue to consult with experienced practitioners and not rely solely on tax forms and instructions.