Intro to Taxes in Web3

Filing your taxes can be a stressful time of the year for many, and if you are involved in Web3, it can be even more stressful. Thankfully, we had the opportunity to chat with Alex Roytenberg CPA about filing your taxes and how to include your Web3 transactions.

Alex is a tax CPA based in New York with over 20 years of experience. He has worked for Morgan Stanley, Goldman Sachs, and PWC to name a few, and currently runs his own practice called NFT.CPA.

He has been involved in crypto and defi since 2018, and more recently he has taken the plunge into the NFT space in late 2020. You can listen to the entire interview we had with Alex on Spotify, or for a quick run-down you can read this article. Let's get into it.

Here is an interview we had with Alex regarding everything Web3 and taxes.

If you are an NFT investor or collector, then the episode below might be better suited for you!

One of the main things that you need to know regarding Web3 and taxes is that you need to report all your crypto activity to the IRS. This is because the IRS considers every single transaction a taxable event. 

How is the IRS going to know if you don’t report your crypto activity? It’s simple, the IRS is doing a lot of the same investing and purchasing of contracts with a lot of the same software vendors used in blockchain activity.

Moreover, everything on the blockchain is recorded publicly, meaning anyone can easily view your transactions.

When it comes to reporting your transactions, all the reporting is done on your 1040 personal tax returns, however, the way your report your activity depends on whether you are a creator, investor, or run a business. Let's break it down by each category.

• Creator (LLC or sole proprietor)
  NFT creators who sell their own NFTs are considered to be a business, so it will go on your Schedule C.

• Investor
  As an NFT investor who buys and sells NFTs, it will go on to what's called your Schedule D as capital gains and losses.

• Defi
  If you are into defi and you create interest or dividends, this will go on your Schedule B.

• Staking and mining
  Staking and mining crypto can either be reported as Other Income Schedule One, or Schedule C.

Ultimately, how you choose to report your earnings depends on what you are doing in the Web3 and crypto space. One important note that Alex made is when filing your taxes, one of the first questions asked is; “Do you have any virtual currency?” It’s a simple yes or no question that you must answer honestly. 

The reason being, is at the end of your tax return on your 1040 you sign the tax return under what's called perjury. What that means is you're saying that you've completely and honestly answered everything on your tax return. 

If there's anything that's out of place and you've signed it, the IRS can come back to you and audit you for those purposes, and say that you've committed some sort of fraud. So, at the very least, make sure that have answered those questions honestly.

According to Alex, every accountant will take a slightly different approach when filing your NFT and crypto tax returns, however, there are some key necessities regardless of who you use to file your returns.

For Alex, the first thing he requires from his clients is all of their Web3 wallet addresses. Once attained, he will then go in and do a data aggregation that will scrape the blockchain to get all of your transactions.

The data aggregation will cover most of your blockchain transactions, however, there may be some transactions that are in question, meaning you might need to provide more clarity as to what those transactions are.

It’s important to note that you only need to provide your Web3 wallet address and never your secret phrase.

Determining whether or not you should hire a CPA is all a question of complexity. Everybody’s situation is different. If you have very few transactions (0-250), you can do it yourself. If you have a significant amount of transactions (300 +), you may want to consider hiring a certified professional.

It’s possible to file your own NFT and crypto taxes using software providers like Zenledger and Cointracker, which can be used with a tax service such as TurboTax. Keep in mind that this option is most suitable for those who have 100 or fewer total transactions, and under $20,000 in profit.

If you have more than that or you have other complexities, doing your own taxes using these software providers might not be the best option for you because you may experience errors that will require manual adjustments that need to be made to the transactions.

As if filing your taxes isn’t already stressful enough, when you add NFTs and crypto into the equation, there’s room for even more error. Here are some of the most common mistakes when filing NFT and crypto taxes according to Alex:

1. Not submitting all your wallet addresses

If you don’t submit all of your wallet addresses, not only will it be impossible to file your taxes accurately, but eventually it will become known that you have additional wallets by looking at your transactions on the blockchain.

It’s important to be upfront about all your wallet addresses and be sure to report all of them to avoid future problems.

2. Commingling wallets (this can create complexities on the reporting side)

Commingling your Web3 wallet with others is not a great idea because this will cause complexities when it comes to reporting, this goes for both personal and business transactions, and will ultimately become an issue.

For example, let's say you and a couple of your friends want to buy a VeeFriends NFT. So, everyone sends you the ETH to make the purchase. This is a bad look in the eyes of the IRS because they might think you received that ETH as compensation and then purchased your own NFT.

This commingling of wallets causes issues from a reporting standpoint as it will likely be difficult to explain, especially when you consider that audits don’t occur six months after a transaction, rather, audits usually happen two to three years later once you have completely forgotten about the transaction.

Instead, Alex recommends creating a separate stand-alone wallet for those specific transactions to make them easier to track.

3. Not keeping a proper record of your transactions

It’s important to keep track of all your NFT and crypto transactions. Some people like to keep an Excel spreadsheet with every transaction detail that occurs, but Alex says it really depends on your transaction volume.

Although an Excel spreadsheet is an option, Alex recommends using an automated data aggregator to keep track of all your transactions. The reason being is that if you are manually entering all of your transactions, you are leaving more room for error as opposed to letting the software track it for you automatically.

The way that the IRS looks at everything is it's all denominated in U.S. dollars. For example, say your purchase 1 ETH for $3500, and then you instantly purchased an NFT for 1 ETH, there’s no gain or loss on that transaction.

But, let's say you sold that NFT six months later for 1 ETH when ETH is worth $2,900. In U.S. dollar terms, the IRS would actually consider that a $600 taxable loss. 

The big thing to remember is, the more cash you're able to monetize from an NFT, the better you are from an end-of-day cash position, opposed to trying to maximize as much of a tax write-off as you can.

It's similar is how tax rates are less than 100%, which means that you're getting less of a write-off against your taxes. When you sell something for a loss, that is considered tax-loss harvesting. So, it reduces your taxable income, not your overall tax bill.

Let's say you have a $50,000 tax bill because you made $100,000 in profits. Additionally, you have a $10,000 loss that you were able to capture from an asset that's down. It doesn't make your tax bill go from $50,000 to $40,000. Rather, it takes your taxable income from $100,000 to $90,000.

Additionally, Alex recommends that you take 30-50% of your revenue and convert it to USD to cover your tax bills. This is important because the value of crypto could drop, and then you are left with less revenue to cover your taxes.

If you are someone who does airdrops, you want to talk to an attorney to make sure the NFTs you are airdropping aren’t considered a security. Since someone is holding your NFT, it’s possible that the IRS will consider it a security.

If your attorney decides your NFT airdrops are not a security, then you might be eligible for tax deductions based on your efforts to provide airdrops to your holders. These efforts can come in the form of marketing expenses, gas fees, and other expenses.

Some NFT attorneys that Alex recommends reaching out to regarding NFTs include Jacob Martin, Moish Eli Peltz, and Alex Lazard.

If you are an investor and you hold your NFTs for over one year, you do get a the benefit of a lower tax rate because your NFT would be considered a long-term investment. Likewise, if you hold your NFT for less than a year, you will be taxed at a higher rate for short-term capital gains.

Alex’s advice however is to consider the value of your NFT investments. If you expect the value to drop more than 10-15% from wherever your NFT sits, you’re better off selling your NFT and taking the short-term capital gains rate as opposed to waiting a year and selling to receive the benefit of long-term capital gains.

The saving in tax rates (24% long-term vs 37% short-term) on a federal perspective, can’t make up for the difference in cash if it drops more than 15%.

Overall, the goal is to hold your NFT to benefit from the lower tax rate of long-term capital gains, but at the same time, you want to be aware of the economics of your particular NFT investment.

• If you don’t have the money to pay your tax bill, you should still file your tax return simply because that will eliminate the penalty that comes with not filing your tax return.

• An extension is an extension to file, not an extension to pay. Meaning that filing an extension isn’t going to give you an extra six months to pay your tax bill.

• Your extension will not be valid if you don’t pay something to the IRS.
  
• If you are filing your own extension, make sure to file with the IRS and your state.

At the end of the day, filing your taxes can quickly become overwhelming especially when you involve crypto-related transactions. However, knowing what to expect and how to be prepared can save you a lot of stress, time, and money.