By David Kemmerer, co-founder and CEO at CoinLedger
At the end of August, the Internal Revenue Service (IRS) and US Department of the Treasury unveiled their long-awaited proposed regulations clarifying the tax information reporting requirements for digital asset brokers. These requirements originally passed into law through the Infrastructure Investment and Jobs Act of 2021.
If these proposed regulations go through as is, digital asset brokers will be required to report customer transactions to the IRS via Form 1099-DA starting in the 2025 tax year.
Unfortunately, these regulations will create more problems than they solve for taxpayers due to the increased reporting complexity that comes with these 1099s. Some observers go as far as to say that these tax rules can permanently handicap the decentralicized finance (DeFi) ecosystem for the US.
Are cryptocurrency taxes changing?
The tax rules for cryptocurrency investors are not changing. Rather, government enforcement mechanisms to ensure that US citizens are compliantly reporting crypto-related income are being updated.
Historically, cryptocurrency brokers — such as exchanges like Coinbase (NASDAQ:COIN) and Gemini — have not been required to report capital gains and losses to the IRS via Form 1099. This differs from the traditional finance world, as stock brokers regularly report trades and other taxable events to the IRS.
As a result of the Infrastructure Investment and Jobs Act and the newly proposed regulations, digital asset brokers will now be subject to the same regulations as the traditional finance world, and they will be required to report customer transactions by the 2025 tax year.
Why is 1099 information reporting troublesome for cryptocurrencies?
Even though they are treated similarly from a tax perspective, cryptocurrencies like Bitcoin and Ether are quite different from a technical perspective than shares of a company. It’s these technical differences that make 1099 information a poor mechanism for reporting gains, losses and income for cryptocurrency traders, even though it is an effective system for stock brokers.
Because cryptocurrencies are built on top of open protocols that anyone can access, users can freely transfer cryptocurrencies and digital assets to and from wallet addresses of their choosing. When investors transfer cryptocurrencies into brokers like Coinbase, the brokers themselves typically don’t have access to critical data like the holding period, cost basis and other tax information about the asset received.
In turn, when the user sells that asset on the exchange, Coinbase and other brokers will be required to report this sale to the IRS on a 1099. However, in this situation, the total gain resulting from the sale will be unknown, as the cost basis from the transferred cryptocurrency is not known.
As cryptocurrency deposits, withdrawals and transfers happen millions of times a day across millions of users all over the world, one can quickly see how the 1099s that digital asset brokers are required to send will be littered with informational holes in them.
Ultimately, this will end up leading to grossly overstated values getting reported to tax agencies like the IRS. It will be up to the taxpayer to prove the true income associated with their digital asset activity.
How will this impact DeFi providers?
The Treasury department’s proposed guidance says that some decentralized finance protocols will be considered ‘brokers’ — though it’s not immediately clear which protocols will fit the requirements.
If DeFi protocols get roped into the “digital asset broker” definition, they will be required to verify their users with Know Your Clients protocol and report capital gains, losses and qualifying transactions to the IRS. It goes without saying that this will challenge the current user experience and purpose of decentralized financial applications as we know them today.
How should taxpayers prepare?
These new regulations will give the US government and other governments a closer look at who should be reporting crypto income on their tax return.
If you have been accurately reporting your crypto income in prior years, you have nothing to worry about with these new regulations. However, taxpayers would be wise to continue to keep tight records of their cryptocurrency transactions across all of the wallets and exchanges.
Additionally, taxpayers should prepare for these new enforcement mechanisms by getting themselves up to date on a tax reporting front. While not a perfect system, 1099 information reporting will be a powerful mechanism for catching tax cheats.
Going forward
Now that proposed regulations have been published by the Treasury, there is a 60 day comment period for the public to provide feedback on the proposal. After the comment period, a public hearing on November 7 will be held. The Treasury will then review and consider “all relevant matters” prior to finalizing regulations.
About David Kemmerer
David Kemmerer is co-founder and CEO of CoinLedger, a leading cryptocurrency tax software company.