Navigating Tax Requirements, Opportunities, and Security Across Digital Assets in 2023

Originally Published at Nasdaq.com - March 16, 2023

If you’re a little confused about how to manage your NFTs and crypto assets, you’re in very good company. Many Americans have turned to digital investments in recent years for a number of reasons - including the appeal of decentralization or simply hoping for higher returns. While financial professionals should be familiar with the ins and outs of taxation on traditional investments, both crypto and NFTs are still relatively new territory. So new, in fact, the IRS still hasn’t issued much guidance. For the moment, we do know these investments are subject to capital gains and income taxes, just like any other investment.  As we untangle the reporting requirements for these tricky taxable holdings, we’ll highlight 3 important learnings:

1. Staking income is taxable

Simply put, “staking” is to digital assets what interest-bearing accounts are to cash - except the stakes are a bit higher (pun intended). Investors are locking up these assets for a set period to support the underlying blockchain's operation. The reward? More cryptocurrency - and, sometimes, quite a bit. We know crypto is a notoriously volatile asset, which makes it a less-than-ideal choice for the faint of heart. But the potential for asymmetrical returns can signal a hefty payday. And the IRS is standing ready to collect its share. Know that reporting requirements apply to any income for activities related to NFTs and cryptos, including mining, exchanging, airdrops, or any other form of receipt of virtual currencies. So, even if you didn’t receive a 1099, you’ll still need to report it.

As usual, the tax you’ll pay is based on the difference between the purchase price and the sales price of the asset when you sell it. Understandably, some argue these assets should not be taxed because staking rewards come in the form of newly-minted cryptocurrency coins. Their justification is this: manufacturers aren’t taxed on the value of a product until they sell it. Which is an interesting point of view. But until the IRS agrees, not reporting these types of transactions - particularly sizable ones - isn’t the wisest option unless you’re open to the risk of getting hit with penalties when they discover your omission. Be sure to maintain your transaction records for anything involving NFTs and cryptocurrencies.

2. The wash sale rule does not apply

On to better news. Unlike traditional securities, crypto and NFTs aren’t currently subject to the wash sale rule. A wash sale is when you sell a traditional security, like a stock, bond, or mutual fund, for a loss so you can claim the loss on your tax return - and then repurchase the security. The IRS considers this transaction a “wash” and will disallow the loss if the repurchase is made within 30 days of the sale. This law is designed to prevent investors from gaming the system.

But what’s interesting is, at least for now, the wash sale rule doesn’t apply to NFTs and cryptocurrency because they are not yet considered securities under the IRS code. Suppose you lose money in NFTs or crypto and want to sell to take advantage of that loss during market dips. In that case, you could go ahead and repurchase it immediately (but know that banning crypto wash sales is on the legislative agenda - so this loophole may soon be history). For now, you can use these losses to offset capital gains and/or up to $3,000 against other income. Any unused losses from the prior year can be applied in future years to offset income.

3. Securing your investment

Consider a custodian exchange for your NFTs and crypto. After last year’s FTX debacle, many investors wanted alternatives to holding digital assets on a cloud-based exchange. Some put their crypto into “cold storage” - a hardware wallet stored offline, making hacking difficult. Unfortunately, it also makes tax harvesting difficult - it’s an extra (often frustrating) step in the way when you need to sell your digital assets. An alternative is to seek out an exchange that can also serve as a custodian - a holding place more accessible than cold storage but safer than a regular crypto exchange.

Custodians offer a secure environment to store and manage digital assets. Exchanges (like FTX) are digital trading platforms where traders can buy and sell. Custodians provide various security features, including advanced encryption technology, cold storage, and two-factor authentication. Noting while these platforms are still subject to risk and that fraud is still possible, custodians are also insured, regulated, and audited, which provides some recourse.