The IRS introduced a new term this tax season, “digital assets,” replacing the previous term, “virtual currency.” So, why the switch? And what could it mean for your clients’ taxes? We’ve got the details below!
What are digital assets, and are they different from virtual currency?
The IRS defines digital assets as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology.” This definition encompasses cryptocurrency, stablecoins, and non-fungible tokens (NFTs).
While the IRS previously used the term “virtual currency” to refer to all these assets, the new term “digital assets” is more accurate. Because NFTs are not currency, the old use of “virtual currency” left some gray areas, leaving many digital asset holders wondering if and how they needed to report their NFTs. The change in terminology is meant to clear up that confusion and prevent digital asset holders from misreporting intentionally or unintentionally.
The IRS still uses the term “virtual currency,” but it has narrowed the definition: “A digital asset that has an equivalent value in real currency, or acts as a substitute for real currency, has been referred to as convertible virtual currency.” Cryptocurrency falls into this category, but NFTs would not.
In short, under the newer definitions, all virtual currencies are digital assets, but not all digital assets are virtual currencies.
Note that the IRS still endorses some older publications that use the term “virtual currency.” For example, their page in “Digital Assets” refers readers to IRS Notice 2014-21 and their Frequently Asked Questions on Virtual Currency Transactions. Although both of these publications use “virtual currency” instead of “digital assets,” their tax guidance is still accurate.
What are common digital assets?
Most digital assets fall into one of these three categories:
Cryptocurrency/convertible virtual currency
Cryptocurrency is by far the most well-known type of digital asset and includes currencies such as Bitcoin and Ethereum. Any cryptocurrency that could be exchanged for fiat (real currency backed by a government) is considered a “convertible virtual currency” and property for tax purposes. This includes virtually all cryptocurrencies, which all have an equivalent value in U.S. dollars or any other true currency.
Stablecoins are a type of cryptocurrency that “pegs” their value to a true currency or another real-world commodity like precious metals. Stablecoins are meant to be less volatile than regular cryptocurrency, making them more appropriate for day-to-day payments and transactions. For tax purposes, they are treated exactly the same as other types of cryptocurrency.
Non-fungible tokens (NFTs)
Unlike stablecoins, NFTs are not a type of cryptocurrency. However, they are digital assets backed by the blockchain. You can think of them as virtual collectibles. They can be anything from a piece of art to a gif to a baseball card; yes, they are taxable.
For more information, see our guide, What Tax Pros Should Know about NFTs and Taxes.
Who needs to answer the new IRS question?
For tax year 2022, all taxpayers must answer the question concerning digital assets on Form 1040. The question is essentially the same as it was in 2021 but has been updated with the newer, more accurate term “digital assets.” It asks, “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
Nearly any transaction involving a digital asset would require your client to check “Yes” and to report all digital asset activity on their tax return. The few transactions that would not be considered taxable and do not need to be reported include transferring cryptocurrency from one personal digital wallet to another or simply purchasing cryptocurrency with real currency without exchanging it for fiat or another cryptocurrency.
How could the new term and question impact your clients’ taxes?
Overall, cryptocurrency and other digital assets will still be taxed as they were in the prior tax year. The new terminology clears up some gray areas, leaving no doubt that NFTs must be reported on tax returns. If your client has NFTs and has not reported them in previous years, now is the time to start.
For further guidance on how to properly calculate and file returns for clients with digital assets, see our guide, What Tax Preparers Need to Know About Cryptocurrency.