What is a digital asset? Cryptocurrency and tax law

From real estate to cryptocurrency, the diverse assets in an investment portfolio collectively define their owner's total wealth. 

Businesses and individuals hold assets for various reasons, including building a financial safety net or generating future income. Each asset class, whether tangible or virtual, carries distinct tax implications with specific rules, according to Internal Revenue Service regulations.

In this guide, we’ll explore the differences between virtual currency and other intangible properties and clarify what a digital asset is for tax purposes.

Understanding how digital assets differ from virtual currency

In general, digital assets are electronically-generated items that come in various forms, such as business logos, websites, e-books, and videos and have real-world value. If it's stored on a computer, transmitted electronically, and has economic value, it qualifies as a digital asset.

For tax purposes, however, the definition is more specific. According to the IRS, a digital asset represents real value recorded on a cryptographically secured, distributed ledger. This includes cryptocurrency, stablecoins, and non-fungible tokens (NFTs).

While the IRS recognizes virtual currency as one type of digital asset, not all digital assets fall under this category. For example, the IRS considers NFTs digital assets, but they don't typically serve as a means for purchases, which distinguishes them from virtual currencies. The IRS uses the term "virtual currency" for certain forms of cryptocurrency, whereas "digital assets" encompasses a broader range of properties.

How to report income from digital assets

Anyone filing forms 1040, 1040-SR, or 1040-NR must answer “yes” or “no” to whether they have received, sold, exchanged, or otherwise disposed of any digital assets during the year. The IRS uses this information to track and tax digital asset transactions. 

Understanding how the IRS defines different types of digital assets is central to taxpayers accurately reporting their holdings and transactions. Here are the two main categories:

Digital assets held as capital assets

If a taxpayer holds a digital asset as a capital asset, they may have different tax implications from those who receive them as compensation. In these cases, the taxpayer must calculate their gain or loss on the transactions and report them on subsequent forms. Keeping detailed records of the price paid for a coin or token and the dollar amount received upon its sale is helpful when determining the fair value of a digital asset. The IRS likewise wants to know if the asset was first a gift before its eventual sale.

Digital assets received as compensation

When a holder receives digital assets in exchange for goods or services, they’ll need to report their value (at the time of compensation). Employees who receive digital assets as income will find their value on their W-2 forms. If an independent contractor accepts the same assets, they may need to file separate forms to report their value accurately.

When to mark “yes” or “no”

Reporting the fair value of a taxpayer's crypto transactions begins with answering the digital asset question on Form 1040. To comply with U.S. tax law, taxpayers must indicate "yes" or "no" regarding their virtual currency transactions on Form 1040.

When to mark “yes”

• Payment for property or services: A taxpayer must mark "yes" if they received any digital assets as payment. This could be from selling property for cryptocurrency or receiving a digital asset as compensation for work. Each instance must be reported in greater detail after answering the digital asset question on Form 1040.
• Gifts: Sometimes, people send virtual currencies or NFTs as gifts to friends and loved ones. Receiving these gifts requires taxpayers to mark "yes" to the virtual currency question. 
• Prizes and rewards: Taxpayers may receive crypto awards in various ways, such as rewards from a cryptocurrency exchange for making larger trades or crypto awarded for participating in online games. In these cases, the recipient must mark "yes" on their tax form.
• Mining, staking, or related activities: Many people mine cryptocurrency by using computers to validate transactions on a blockchain network and receive compensation for their efforts. Others stake their cryptocurrency for rewards, meaning they lock it in the care of a network validator who shares the earnings they've received for helping authenticate transactions.
• Hard forks: These occur when an internal dispute causes a faction of cryptocurrency developers to split off from the rest, resulting in a new coin. The blockchain then automatically distributes the new coin to the original holders. If a taxpayer receives a coin or token due to a hard fork during the tax year, they must mark "yes" on their tax form.
• Exchanges for property or services: Trading cryptocurrency for property or services outside of regular employment also requires taxpayers to mark "yes" in response to the digital asset question. Detailed records will help determine the fair value of these assets at the time of compensation.
• Swaps and trades: Trading digital assets for one another, often referred to as swapping when exchanging cryptocurrencies within a digital wallet, also requires the taxpayer to mark "yes" in response to the IRS's digital asset question. 

When to mark “no”

Not every situation calls for a "yes" on your 1040 form when it comes to digital assets. Here are a few things to think about when deciding how to answer the IRS:

• Ownership of digital assets: If a taxpayer doesn't own any digital assets and hasn't disposed of any during the tax year, they should mark "no." With nothing to report, they can proceed to report their income and other tangible assets.
• Digital asset transactions during the year: Many taxpayers hold crypto for the long term. If a taxpayer has held NFTs, stablecoins, or other cryptocurrencies for the entire tax year without selling or transferring them, they can safely mark "no" to the digital asset question.
• Transfers between wallets or accounts: If a taxpayer holds digital assets long-term but transfers some or all of them between different wallets they own, they can still mark "no" on their 1040.
• Purchases with U.S. dollars: If a taxpayer purchases a digital asset using U.S. dollars rather than crypto, they can mark "no" to the digital asset question on Form 1040. This applies even when the taxpayer uses centralized cryptocurrency exchanges to make purchases.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.