The meteoric rise of cryptocurrencies has minted a new generation of millionaires and resulted in the mainstream adoption of virtual currencies as an increasingly important asset class. The crypto boom has also raised questions on how miners/stakers, investors, and other players can best transfer these digital assets to their heirs from a tax and estate planning perspective. For example, how do you ensure your heirs can control and inherit a virtual asset that, by design, has no personal identifying information and requires a passcode to access after you pass away? What are the estate and federal income tax implications of an inheritance of crypto assets that may have substantially appreciated at the time of transfer? Are there ways to minimize federal gift and estate taxes on the transfer of digital assets? We cover these questions and other issues further below.
For traditional assets like real estate or stock brokerage accounts, there is typically a certificate or another legal document identifying the owner of such assets. By contrast, cryptocurrency networks are largely decentralized, meaning users conduct and police financial transactions occurring within the system rather than a centralized authority.
An individual will usually store cryptocurrencies in a digital wallet, which is assigned a blockchain address that allows users to send and receive crypto assets. The wallet is secured by a private numeric key that must be input before any transaction can occur with respect to that wallet. Thus, unlike traditional assets, there is no personal identifying information associated with the crypto assets and the wallet can only be accessed through the private key.
The pseudonymous nature of cryptocurrencies creates unique challenges for estate planning. First, given that cryptocurrencies stored in a wallet do not have personally identifying information, the assets will essentially die with the decedent if he or she fails communicate such assets exist. Even if the assets are identified, estate planners and their clients must provide detailed instructions on how to access the wallet (i.e., the private key) and consider passing down assets to heirs with a baseline knowledge of using and managing cryptocurrencies.
Federal Gift and Estate Tax Implications
As described in previous postings, the IRS treats cryptocurrency as property for federal tax purposes. Thus, the federal gift and estate tax rules governing property transfers such as real estate and stocks apply to crypto assets.
As of 2022, the lifetime estate and gift exemption for single filers is $12.06 million and $24.12 million for married couples filing jointly. This means that a taxpayer can gift and leave up to $12.06 million (and $24.12 million for married couples) to her heirs and pay no federal estate taxes on the transfer. The first million in excess of the federal exemption will be taxed at graduated rates, with any amounts over a million taxed at the 40% top rate. Certain deductions such as mortgages, debt, and charitable gifts are excluded for purposes of calculating the exemption. Accordingly, if the fair market value of the cryptocurrency, along with other transferred assets (less certain deductions), is more than $12.06 million, any amounts in excess of the exemption will be subjected to federal estate taxes. By contrast, the beneficiary will not be taxed on the receipt of the cryptocurrency and her basis in the crypto assets will be stepped up to the value at the time of the benefactor’s death.
By way of illustration, assume that Peter, a single father, has crypto assets worth $7 million and real estate valued at $6 million, with a mortgage of $1 million at the time of his death. Under his will, the assets are set to be transferred to his son William. Although the value of the transferred assets exceeds $12.06 million (i.e., $13 million in value), the $1 million mortgage on the property will allow Peter’s estate to be below the exemption (i.e., $12 million). As a result, Peter’s estate will not be required to pay any federal estate taxes. Assume instead that the value of Peter’s crypto assets are worth $8 million. Peter’s estate will now be required to pay estate taxes because the value of her assets will be more than the $12.06 million threshold (i.e., $14 million value less $1 million mortgage). William’s basis in the crypto assets would be stepped up to $7 million and $8 million under the first and second scenario, respectively.
Minimizing Gift and Estate Taxes
Although the federal estate tax is paid by a small portion of the population – only .07 percent of all decedents paid the tax as of 2019 – there are planning techniques to minimize estate taxes for individuals who anticipate that their crypto holdings will substantially appreciate in value during their lifetime. First, if a taxpayer holds newly circulated coins with a low current value but believes the tokens will increase in value overtime, the taxpayer can gift the assets to a designated donee. As mentioned above, taxpayers have a lifetime gift and estate tax exemption of $12.06 million (and $24.12 million for married couples) in 2022. Thus, if a taxpayer gifts the crypto assets when the FMV of the coins are low, any appreciation after the gift transfer will escape the estate taxes upon the taxpayer’s death. To illustrate, suppose Erin, a single filer, holds 100,000 ANKR tokens, a relatively new crypto asset, when the price per coin is $0.09 (or a total value of $9,000). When Erin passes away, the price per coin is $200 (or a total value of $20 million). For purposes of this example only, further assume that the 40% top rate applies to any amounts in excess of the federal exemption. If Erin simply leaves the ANKR coins to her heirs when the value per coin is $200, her estate would be liable for estate taxes in the amount of approximately $3.176 million ($20 million – $12.06 million x 40%). If Erin, however, decides to gift the ANKR coins when the value is $0.09, the $7,940,000 of appreciation in excess of the lifetime exemption would not be subjected to estate taxes.
Alternatively, a taxpayer could potentially avoid estate taxes while obtaining a current tax benefit through donating crypto assets to a charity. In doing so, the individual would receive a charitable deduction equal to the value of the assets at the time of donation and potentially avoid estate taxes on any post-donation appreciation of the assets at death.
Given the unique features of cryptocurrencies, careful consideration must be given to ensuring such assets are accessible after the benefactor passes away and are transferred to heirs with a baseline understanding of how to manage crypto assets. Additionally, the substantial appreciation in value of cryptocurrencies over the last few years has made advance planning to minimize gift and estate taxes even more of a priority for investors and miners alike.