Digital asset reporting: How the IRS’s proposed regulations could change tax collections
The Department of Treasury recently issued long anticipated proposed digital asset regulations under IRC Section 6045 regarding the implementation of information reporting as required by the Infrastructure Investment and Jobs Act of 2021. These regulations are a sea change in the type of information the IRS will receive with regards to digital asset transactions – brokers and taxpayers transacting in digital assets will need to take notice. It is believed that the implementation of these proposed regulations will bring in significant tax revenue that is currently uncollected, as well as bring the U.S. closer in line with the Organization for Economic Cooperation and Development (OECD) Crypto-Asset Reporting Framework (CARF) digital asset reporting requirements.
The implementation of these regulations will take some time and none of these regulations are immediately effective, but those that are covered by the regulations should start preparing for the impacts now. Much of the burden will fall on taxpayers who operate in niche areas of the digital asset ecosystem and those taxpayers will be forced to undertake significant steps to comply with the regulations. For the average taxpayer who holds digital assets as investments, there are some short to medium term impacts on what information the IRS is going to receive on digital asset gains and losses.
Standardized reporting
The clearest change in the proposed regulations is that digital asset reporting is going to shift to a more standardized format. These regulations require broker dealers to file a Form 1099-DA that is expected to be functionally equivalent to a 1099-B, Proceeds from Broker and Barter Exchange Transactions. The new format will serve as a replacement for the various 1099-B, 1099-K or 1099-MISC that have been issued by various digital asset institutions in an effort to report digital asset transactions without an appropriate form. The 1099-DA will include the taxpayer’s name, address, and tax identification number as well as the gross proceeds of the sale.
While basis is also required to be reported the proposed regulations, there are known issues with regards to how accurate the basis reported on the 1099-DA will be. Currently, the proposed regulations adopt the language of the securities regulations and will require companies who are subject to the definition of broker dealers in the proposed regulations to include adjusted basis on the 1099-DA to the extent it is known by the broker. To capture basis of assets purchased on one platform and then transferred to another platform, Treasury has stated that it is going to issue parallel regulations not only to require basis reporting upon sale but also for a transfer between reporting agents. These regulations will come into effect subsequent to the current proposed regulations. Under the current proposed regulations, there will be no adjusted basis reported on the 1099-DA if a self custody digital asset is transferred to and sold on a covered exchange. The net effect of this is that the 1099-DA will effectively report a gain equal to gross receipts for the sale of assets that were held on a cold (offline) wallet.
Despite the introduction of many new concepts or forms, the IRS did take significant effort to maintain harmony with many other existing provisions in the tax code. Digital asset payments for real estate will still be subject to the same income exclusion provisions for the sale of a primary residence. Many of the definitional changes adopt the same language as established securities or commodity rules. For many taxpayers that only occasionally transact in digital assets the impact of these regulations will be minimal, and the 1099-DA may be a net positive because it will allow for consistency across brokers.
Major changes for decentralized exchanges
One area that will see profound change will be for digital asset transactions that occur on a peer-to-peer level on a decentralized exchange (DEX). While not identical with the OECA CARF regulations, exchanges that operate a peer-to-peer exchange and receive income from facilitating the exchange will be required to collect know your customer (KYC) information and report transactions between users. This type of requirement is onerous for the exchanges because they are not normally privy to such information and are going to have to materially alter their business model to comply with the requirements.
Timing and impact
While the regulations are currently in proposed format, it is likely that the final version of the regulations will closely mirror the proposed version. Closing the tax gap associated with digital assets is a high priority for the IRS and Treasury, not to mention other taxing jurisdictions that will benefit from the CARF requirements. Under the proposed rules, information on sales and exchanges of digital assets in 2025 would be required to be reported in 2026. While the current expected effective date is still a few years away for sales and exchanges, even that date is ambitious given the time needed to review and address the expected volume of comments on the proposed regulations, as well as the time needed for the covered brokers to implement solutions.
The overall impact on Americans is significant. Based upon the number of taxpayers who have answered yes to the digital asset question on the 1040, Treasury estimates that between 13 and 16 million taxpayers will receive a 1099-DA once implemented. They further estimate that roughly 5,000 brokers will be subject to the requirements. The best thing for both individual taxpayers and brokers to do currently is to prepare for significant changes to how digital asset sales and exchanges are reported to the federal government.
For more information on this topic, or to learn how Baker Tilly specialist can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
