With nearly one in five U.S. adults diving into cryptocurrencies, it's about time crypto gets its own tax form. But is it the boon we've been waiting for, or just another thorny path we're forced to tread?
The IRS has recently unveiled proposed regulations that shine a light on the murky world of digital asset broker definitions, the intricacies of the new Form 1099-DA, and its implementation timeline. With an Oct. 30, 2023 deadline for public feedback, these regulations arrive in an era where cryptocurrency, despite its global proliferation, lacks a dedicated tax form for reporting profits or setbacks.
While Form 1099-DA's raison d'être is to streamline the tax process, its introduction could unravel a tapestry of complexities for brokers, tax preparers and everyday taxpayers. Navigating its challenges becomes imperative.
Expanding the "broker" definition
The U.S. Infrastructure and Jobs Act has ushered in a new era of "broker reporting" rules for essentially categorizing digital assets as securities and compelling centralized crypto exchanges to issue Form 1099-DA, much like stock-trading firms issue 1099-Bs for securities transactions.
But the IRS doesn't stop there. Its proposed regulations widen the "broker" net to include anyone "in a position to know" a seller's identity, even those whose roles might just be facilitative. Popular decentralized crypto platforms like Uniswap, OpenSea and Etherscan may even be forced to shut their digital doors to U.S. users.
Potential problems with data exchange among digital asset brokers
For 1099-DA to achieve its noble intentions, digital platforms must willingly exchange cost basis data during asset transfers. While standard among stockbrokers, this practice is trickier in the crypto universe. Transfers between digital asset platforms are more frequent and can happen multiple times within a single transaction. Currently, these platforms aren't designed to seamlessly share this crucial cost-basis data.
Imagine you acquire some cryptocurrency directly within your crypto wallet. Later, you decide to transfer it to the crypto exchange Coinbase, where you sell it. Coinbase must report both the cost basis and the sales proceeds on Form 1099-DA. But what happens if the wallet provider never communicates the cost basis to Coinbase? In such a scenario, Coinbase would either have to report a cost basis of zero or indicate the data is unavailable.
Given these complexities, these newly categorized brokers are incentivized to take a conservative position, often resulting in an assumed cost basis of zero. This will either penalize taxpayers, or they will likely need to rely on specialized crypto tax software or consult professionals to rectify any gaps in cost-basis information.
Third-party vs. self-reported information
The tax system operates on a self-reporting basis in the United States, meaning it's up to the individual taxpayer to calculate and file their own taxes. Generally, there are two types of information that taxpayers provide:
- Data reported by third parties, such as employers or financial institutions, which usually comes in the form of W-2s, 1099s and 1098s; and
- Information that taxpayers themselves report, covering income, expenses or deductions not captured by third-party forms.
Traditionally, these two reporting streams have been distinct. However, the introduction of new broker-reporting regulations for cryptocurrencies has blurred these lines. Now, taxpayers find themselves in a hybrid situation where they must reconcile self-reported data with third-party information. This is particularly challenging in the crypto space, where multiple exchanges may each offer only a limited snapshot of a taxpayer's overall crypto activity. One might even say this is novel, as it's not clear at this point if there's a good way to correct cost basis data reported by brokers.
The taxpayer is then left with the complex task of piecing together these fragmented reports to form a complete picture for tax purposes. Adding to the complexity is that individuals involved in crypto trading often have a significantly higher number of wallets and exchange accounts than traditional stock or bank accounts.
Self-transfers
Many individuals who deal with cryptocurrency taxes often use multiple exchanges and digital wallets. While moving crypto assets between these platforms isn't a taxable event, the platforms themselves frequently struggle to distinguish between such self-transfers and transactions that are actually taxable.
As a result, there's a high likelihood that Form 1099-DA may mislabel these self-transfers, leading to inflated reported proceeds. Such discrepancies between the actual and reported figures could potentially flag an audit.
To mitigate these issues, it's advisable to meticulously report all transactions on IRS Form 8949.
Cost basis challenges
In the U.S., taxpayers have the option to use either the First-In, First-Out method or specific identification for determining the cost basis of their cryptocurrency, similar to how it's done for traditional securities.
In traditional finance, taxpayers can notify their securities broker to use specific identification and then guide them on which tax lot to sell. However, the crypto landscape doesn't operate this way. Neither exchanges nor crypto tax software offer mechanisms for presale identification, leading exchanges to default to FIFO-based cost basis reporting on Form 1099-DA.
Taxpayers often employ various methods as stand-ins for specific identification, identifying the cost basis post-sale rather than presale. But if exchanges report using FIFO while the taxpayer opts for specific identification, reconciliation becomes an insurmountable challenge. This discrepancy can result in double-counting or omitting the cost basis, as both parties use incompatible methods for calculating it.
To navigate these complexities, taxpayers should track cost basis at a granular level — per wallet, per exchange and per asset. Given the intricacies involved, using specialized crypto tax software becomes not just a convenience but a necessity.
Gross proceeds: a misleading metric
The "gross proceeds" concept on IRS Form 1099-DA signifies the total sales revenue generated on a particular exchange, wallet, or other brokerage service. It doesn't factor in capital gains or losses.
Take an example where you sell $75,000 worth of cryptocurrency on Coinbase within a year. If your original investment on Kraken was $150,000, and no additional data was exchanged, you're actually at a financial loss. Form 1099-DA would only indicate the $75,000 you've sold, creating a false impression of taxable income.
How brokers and taxpayers should prepare
Brokers should invest in robust systems capable of accurate reporting, including sharing cost-based information with other platforms. They should also be prepared to report essential details like name, address, proceeds, transaction ID and wallet address for each sale they facilitate.
Taxpayers should consider using specialized crypto tax software to reconcile the information on Form 1099-DA with their actual transactions, especially if they use multiple platforms or engage in self-transfers. During an audit, the first thing the IRS asks for is a list of your wallets. Carefully tracking your wallet portfolio is essential.
While regulation is an inevitable and necessary step for the maturing crypto industry, Form 1099-DA, as it stands, is a minefield of complexities and pitfalls. All stakeholders must understand these challenges and prepare accordingly, lest they find themselves lost in a tax maze with no easy exit.
