A scenario for you:
You’re a young millennial who spends his or her mornings perusing your most trusted source of internet news (I, of course, am referring to Reddit) in November of 2020. A hot tip involving a potential short-squeeze opportunity to profit off of an investment in a retail video game corporation pops off of the pages of the financial section of the WallStreetBets Journal. Being the prudent and savvy investor that you are, and adhering to such long-standing financial maxims as “you only live once” (YOLO) as originated by our financial forefathers, you make a modest investment of $5,000 towards your financial future.
Fast forward two months later…
Shrugging off the critics accusing you of possessing hands made of paper, you decide to sell your stock in the aforementioned video game company in late January. Your $5,000 investment in that company at roughly $12 per share has blossomed into a modest $166,400 at a sale price of $400 per share (or about half that, if your trading platform failed you). Don’t worry though, because…
On that same day, you’re engaging in good-natured and well-informed economic discourse around the family table when your equally well-informed cousin reminds you of a unique opportunity to invest in a blockchain-based decentralized currency modeled after an adorable canine. The investment itself has already seen a 800% gain in the past month, from a measly $0.005 per “coin” to a sizable $0.04!
Again, not one to pass up a surefire blue chip investment, and after performing sound due diligence on Twitter, you take your cash from the sale and make a similar “YOLO” investment in a similar blue-chip, in order to achieve the long-sought “tendies”[1] that have formed the backbone of our economy.
You hold (or I suppose I should say, “HODL”) your investment until Mother’s Day weekend, when the fear of a potential flop of a performance on Saturday Night Live (which somehow matters here) costing you your profits prompts you to cash out. Your $5,000 turned into $166,400 from the video game company, reinvested at $0.04 per coin, is now sold at a maximum value of $0.70 per share.
When your friends correct you for calling it a share, you remind them that your total value of that initial investment of $5,000 is now $2,912,000, and you can call it pretty much whatever you want.
While the scenario above may sound Hollywood-esque in nature, the fact remains that scenarios like this have popped up across the country. Over the past few months, an investing sensation driven by social media has caused many retail investors to achieve gains on investments reserved typically for those far more “in the know”.
With this sensation comes with it an equally large question of the taxation of these investments. In many cases, these newbie investors will find themselves facing taxation on investment-based gains for the very first time. We will discuss possible tax consequences on “meme stocks” (or investments in publicly traded corporations that have become increasingly popular based on being in the spotlight of social media platforms like Reddit and Twitter), first.
Taxation of Gains on the Sale of Stock
My inspiration to write this article came from a second-hand story of an individual who had turned a profit and had subsequently formed a plan on how to spend their earnings. Their notable omission, of course, was to account for the federal and state tax impact on those earnings. If you fall under the fortunate category of one who purchased stocks such as GameStop, AMC, or many of the other “meme stocks” at a time when they were trading at a fraction of their current or maximum value, I’m going to break down the impact on your taxes based on a broad spectrum of scenarios:
Scenario 1 – I bought my stocks, and have yet to sell them.
For starters, as I (and most of the natural world I would assume) have learned over the past six months, this would place you in the category of one with “diamond hands”. If you fall under this category, from a tax perspective, you currently have what are referred to as “realized” gains or losses. Simply put, when you look at your portfolio, you can see that the stock, if sold today, is worth more or less than what you purchased in the past. From a tax perspective, you have yet to trigger a “recognized” gain or loss by selling the security, and therefore, have yet to trigger a taxable event. Only upon the sale of some or all of the security are you met with the burden of the impact on your taxes.
Example – If in my scenario above, the investor still held his meme stock, and did not sell in January (or any time during the year), he would not have a recognized gain or loss for income tax purposes.
Scenario 2 – I bought my stocks, and sold them at a gain.
In this scenario, (the “paper hands” scenario, if we are going by Reddit) by selling the securities that you purchased, you have, in fact, triggered a taxable event. If the sale price was greater than the purchase price and a gain has been recognized, the main takeaway to grasp here is the matter of “when” dictates whether or not your gain will be subject to tax at your ordinary income tax rate (up to 37% for federal tax purposes in 2021[2]) or at a preferential, lower, capital gain tax rate (up to 23.8% for federal tax purposes in 2021 for high-income taxpayers subject to the Net Investment Income Tax).
In general, a stock must be held for at least a year in order to receive the preferable, long-term capital gain treatment as just stated. An investment held for less than a year, categorized as a short-term capital gain, is subject to ordinary, higher income tax rates.
Example – In my wild scenario above, the stock purchased in November of 2020 and sold in January of 2021, and thus held for less than a year, would be subject to ordinary tax rates. Assuming my “YOLO” investor now finds themselves in the 37% tax bracket due to all his earnings, that initial gain of $161,400 (the sale price less the $5,000 purchase price) would carry a tax liability of $59,718.
Scenario 3 – I bought my stocks, and sold them at a loss.
For just as many who boarded the bandwagons back in 2020, there are infinitely more who got on too late in 2021. For these investors who opted to cash out and lock in a recognized loss, they must first use their losses to offset any capital gains in the same year. If, when all the math is done, losses exceed gains, taxpayers can offset up to $3,000 in a tax year against their ordinary income. If there is any excess loss, that loss is banked as a capital loss carry-forward, to be used in future tax years. As of right now, that loss can be carried forward indefinitely.
Example – In a less wild scenario, if an investor bought and sold stocks at a total net loss of $10,000 in a taxable year, and had no other capital gains for which the loss could be offset, he or she would be able to deduct $3,000 of that loss against their ordinary income in that taxable year. The remaining $7,000 would be carried forward to be used (hopefully against future gains) in years ahead.
Scenario 4 – I bought and sold and bought and sold and….
If you fancied yourself a day trader, and attempted to buy low and sell high as many times as possible during the first half of the year, remember two key facts:
- First, if you sold, you triggered a taxable event, regardless of if you bought the same stock over again a day later.
- Second, if you bought a stock, sold it at a loss, and then bought it back within 30 days, the IRS states that this constitutes a “wash sale”, rendering your loss nondeductible.
Example – An investor buys a stock for $1,000 on Monday, sells that stock for $2,000 on Tuesday, and then buys back the same stock for $1,800 on Wednesday and holds for the rest of the year, his or her tax liability is on the recognized gain of $1,000 (the $2,000 Tuesday sale less the $1,000 Monday purchase).
In a similar scenario, the person that investor bought the stock from, who bought the stock at $2,000 on Tuesday, sold it back at $1,800 on Wednesday, and then bought back the same stock on Thursday, is unable to deduct the $200 loss he or she recognized, under wash-sale rules. The loss is not gone forever though. It gets added to the basis of the stock that was purchased, so will be recovered when the replacement stock is eventually sold.
Now for the Crypto…
First, let’s start with the easy part. If you are like many who jumped into the crypto game as an investment this year, or for those of you who are savvy vets, the IRS deems cryptocurrency to be property for income tax purposes. As such, just like stocks, the same rules apply in terms of holding period, gain and loss rules, wash sale rules, etc.
In the example above, the investor who used his $166,400 and turned it into a $2,745,600 cryptocurrency-based profit, on a holding period of less than a year, would trigger a Federal ordinary income tax liability of $1,015,872 (as well as an additional 3.8% of Net Investment Income Tax on the capital gains that fall within this threshold). For some platforms that may not offer brokerage-style reporting that explicitly states the cost basis, sale price, and gain, it may be necessarily to keep track of your basis manually in order to accurately report your gains and losses as they are recognized. Beyond that is relatively straightforward.
The tricky part is that cryptocurrency is, as can be seen in establishments across the globe, a currency. Even better than that, it is a currency you yourself can create or mine (if you were hoping for an explanation of how that works, you’ve come to the wrong place).
For those of you who fit the description of a crypto-miner, the value of the cryptocurrency (as it is mined) constitutes ordinary income. If you engage in this mining at a level that constitutes a trade or business, you can offset your revenue with expenses that are ordinary and necessary to carry on this activity under IRC 162 (just like any other business). However, also like any other trade or business, the net earnings from this activity are also subject to self-employment taxes.
If, on the other hand, you are merely dabbling in cryptomining as a hobby, then the revenue generated would be reported as other income on your personal tax return and would not be subject to self-employment taxes. But, before you go racing out the door to buy that brand new computer you had your eye on, remember that under the Tax Cuts and Jobs Act, expenses related to hobbies are nondeductible, and are ineligible to be used to offset those cryptomining profits as a hobby.
In either event, it is important to note that the tax recognition event is when the cryptocurrency is mined and not just when it is sold. When it is sold, those transactions are recorded in the same manner as if it were bought and sold under a brokerage account or other exchange.
Example 1 – An individual mines cryptocurrency as a hobby and accumulates $10,000 worth of X-Coin in January through March of Year 1. They then sell X-Coin on an exchange for $15,000 in June of Year 1. On their Year 1 Federal tax return, they would recognize $10,000 of Hobby Income as “Other Income” and $5,000 of Short-Term Capital Gain (The 15,000 less the 10,000 of basis recognized) on Schedule D. Ultimately this $15,000 is all subject to ordinary income tax rates.
Example 2 – Same facts as in Example 1, but the individual sells the X-Coin for $15,000 in June of Year 2. Their Year 1 Federal Tax return would still recognize the $10,000 of Hobby Income as “Other Income”, and their Year 2 Tax return would reflect a $5,000 Long-Term Capital Gain, subject to the preferential capital gains rates.
One Checkbox to Attend to:
The last note on those of you investing in cryptocurrency is to pay close attention to the now two-year old question found on page 1 of your Form 1040 U.S. Individual Tax Return dealing in cryptocurrency. It is a mere check-the-box declaration that, during the tax year, you did in fact deal in cryptocurrency in some manner[3]. Just as much as my savvy investor friend in the example above is informed on the popularity of cryptocurrency, so is the Internal Revenue Service.
Failing to accurately disclose this on your return (even if you may have bought and held, and therefore, have no actual tax recognition event in that year) may constitute a willful omission of fact if under audit in the future. Much like issues stemming from foreign asset holdings and investments, the cryptocurrency issue is one the IRS will most certainly be targeting for additional disclosure in the coming years.
Navigating this brave new world of investing can be fun and exciting. It can also have significant federal and state consequences that should not be ignored and should be planned for as soon as possible. If the contents of this article ring close to home and you find yourself unsure of the tax issues related to your situation, please do not hesitate to contact our office.
Article Submitted by – Anthony C. Panetta, CPA
[1] For those in the know, tendies are profits on investments
[2] Tax rates are as of the date this article was written and are subject to change.
[3] If your only transaction is BUYING virtual currency with REAL currency, that technically does not require checking the box.
