Thousands of U.S. residents have invested in the cryptocurrency market. But as that market rises and falls, investment decisions can result in substantial tax consequences -- for you and your heirs after you pass away. Find out what we know about cryptocurrency tax planning and what you can do to protect your family from unexpected Bitcoin inheritance tax.
Cryptocurrency has been around for over a decade; Bitcoin became accessible to the public in 2009. However, the laws related to how cryptocurrency works have lagged behind. The IRS issued its first Notice about tax on cryptocurrency and Bitcoin inheritance tax in 2014. The government treats all “virtual currency” as property, rather than cash. That affects the way crypto users must track and report their Bitcoin transactions and how much their heirs will pay in estate taxes after they have passed away.
The IRS requires you to report all your income on your annual tax returns. This includes your wages, interest income from investments, and capital gains and losses from property transfers. That’s where Bitcoin comes in. Technically, every time you transfer cryptocurrency you are selling or buying a piece of virtual property. The IRS says those sales result in capital gains (if you made a profit), or losses (if you didn’t), which can result in income tax obligations. In recent years, the IRS has begun to investigate and crack down on Bitcoin investors and other cryptocurrency users who fail to report or pay their cryptocurrency tax.
But crypto doesn’t always fit well into the property-transaction model. A second IRS notice in 2019 answered two specific questions about situations unique to cryptocurrency tax:
However, there are still many questions unanswered about how users can invest, trade, gift, and take advantage of their crypto accounts. If you are tax planning for cryptocurrency, you should work with an attorney and accountant who are up-to-date on the technology and how the IRS and your local government are treating it.
Many investors are starting to use gifts as a way to avoid income tax on their crypto wallets. Taxpayers are entitled to charitable deductions when they donate appreciated cryptocurrency to eligible nonprofits. Cryptocurrency “appreciates” if it is worth more at the time of the transaction than it was when you purchased it. If you make a charitable transfer of cryptocurrency, you can take advantage of that appreciation, using it to offset other gains for the year.
However, because crypto is property, the process of giving cryptocurrency as a gift, whether it is gifted to a charity or a family member, isn’t as simple as writing a check. You need to properly track and document the “cost basis” of the virtual property. But unlike other parts of your investment portfolio, crypto doesn’t have a broker in charge of tracking those investments. It’s up to you, the investor, and that can be difficult. Some companies have now created apps to help you determine the spot price for each Bitcoin at the time it was purchased.
When you use Bitcoin for transactions, you calculate your capital gain by comparing the cost basis with the fair market of the item or service received in exchange. However, when you give crypto as a gift, there is nothing to set the fair market value behind the transaction to calculate the value of your gift. The best practice for cryptocurrency gifts (charitable or otherwise) is to get a qualified appraisal of the fair market value of the virtual currency on the date of the transfer which will include all the information the IRS needs to document the exchange and what it was worth to the gift giver and the recipient.
The capital gains consequences of cryptocurrency transactions require careful consideration in estate planning as well. If your heirs receive thousands of dollars in appreciated crypto assets, they could face substantial Bitcoin inheritance tax consequences. It is important to anticipate those tax consequences while planning your estate. This may include making cash available to pay the IRS what is owed, or using alternative estate planning methods, including various forms of revocable or irrevocable trusts, to reduce the taxable events. Even then, you should require your trustee or other fiduciary to work with an experienced estate administration attorney to ensure the virtual assets are properly maintained and distributed when the time comes.
Tax planning for cryptocurrency assets remains unpredictable, and not just because the value of Bitcoin can change rapidly. To make the most of your assets today and leave the most value to your heirs tomorrow, be sure to work with estate planning attorneys familiar with cryptocurrency to accommodate your tax planning and asset protection needs.
At Harrison Estate Law, we understand the tax and estate planning issues surrounding Bitcoin and other types of cryptocurrency. Our founder, McCabe Harrison, has an advanced degree (LL.M.) in tax law, and years of experience preparing complicated estates. We ensure all our estate plans, including Wills and trusts, account for our clients’ digital assets, and anticipate the tax consequences that come with distribution. We are happy to meet with you to review your crypto assets and prepare an estate plan that shields them from unnecessary payments to the IRS. Please contact us online or via email or call 352-559-9828 to schedule a free consultation. If you don’t live close to Gainesville we are happy to set up a phone or Skype call.