With 1 in 5 people in the United States trading cryptocurrencies, it's time cryptocurrencies got their own tax form. But is this the blessing we are waiting for or is this another thorny path we are forced to tread?
The IRS recently released proposed rules that shed light on the murky world of defining a digital asset intermediary, the complexities of the new Form 1099-DA, and the timeline for its implementation. These rules, which are subject to public comment until October 30, 2023, come at a time when, despite the global diffusion of cryptocurrencies, there is no specific tax form for reporting profits or losses.
Although the primary purpose of Form 1099-DA is to simplify the tax process, its implementation can present a number of challenges for preparers, tax return preparers, and ordinary taxpayers. It is important to manage your difficulties.
Expand the definition of “Broker”.
The US Infrastructure and Works Act ushered in a new era of “interim reporting” rules to classify digital assets as securities and force central cryptocurrency exchanges to issue US Form 1099-DA. Similarly, publicly traded companies issue 1099-Bs for securities transactions. . ....
But the IRS doesn't stop there. The rules he proposes expand the network of “intermediaries” to include anyone “with the possibility of knowing” the identity of the seller, even those whose role may be merely instrumental. Popular decentralized crypto platforms such as Uniswap, OpenSea, and Etherscan may even be forced to close their digital doors to US users.
Potential issues with data exchange between digital asset brokers
To achieve the lofty goal of 1099-DA, digital platforms must voluntarily share cost-based information when transferring assets. Although common among stock brokers, this practice is more complicated in the world of cryptocurrencies. Cross-platform transfers of digital assets are more frequent and can occur multiple times in a single transaction. Currently, these platforms are not designed to transparently share this important price-based information.
Imagine that you have earned cryptocurrencies directly in your crypto wallet. Then decide to transfer it to Coinbase, the cryptocurrency you are selling. Coinbase must report both cost basis and revenue on Form 1099-DA. But what if the wallet provider never interacts with Coinbase based on cost? In such situations, Coinbase must report a zero value or indicate that the data is not available.
Given this complexity, these newly qualified brokers are encouraged to take a conservative stance, which often results in a zero cost assumption. This will penalize taxpayers who will either have to rely on dedicated crypto tax software or consult professionals to fill in gaps in expenditure-based data.
Third-party data versus self-reported data
The U.S. tax system operates on a self-filing basis, meaning it is up to individual taxpayers to calculate and report their own taxes. Generally, taxpayers provide two types of information:
- Information provided by third parties, such as employers or financial institutions, typically on Forms W-2, 1099 and 1098; AND
- Information about taxpayers' personal returns that includes income, expenses, or deductions not included on third-party forms.
Traditionally, these two reporting streams are separate. However, the introduction of new broker reporting rules for cryptocurrencies has blurred these lines. Taxpayers now find themselves in a hybrid situation where they must reconcile their own declaration data with those of third parties. This is particularly difficult in crypto, where multiple exchanges can only provide a limited copy of each contributor's total crypto activity. You can say this is new because it's not clear at the moment if there is a good way to adjust the data based on broker-reported costs.
The taxpayer is then faced with the complex task of piecing together these fragmented returns to create a complete picture for tax purposes. Adding to the complexity is the fact that people who trade cryptocurrencies have more wallets and exchange accounts than traditional bank or stock accounts.
Automatic transfer
Many people facing cryptocurrency taxes often use multiple exchanges and digital wallets. Although the transfer of cryptocurrencies between these platforms is not a taxable event, the platforms themselves often have difficulty distinguishing between these self-transfers and truly taxable transactions.
As a result, Form 1099-DA is more likely to incorrectly label these self-transfers, thereby increasing reported income. These discrepancies between actual and reported figures may indicate an audit.
To reduce these problems, it is recommended that you carefully report all transactions on IRS Form 8949.
Cost Basis Issues
In the United States, taxpayers have the option of using the first-in, first-out method or a special identification method to determine the cost of cryptocurrencies, as they would for regular securities.
Traditionally, taxpayers could ask a broker to use certain identifiers and then tell them which tax lots to sell. However, the cryptocurrency landscape does not work that way. Neither exchanges nor crypto tax programs provide pre-sale identification methods, making exchanges eligible for FIFO-based cost reporting on Form 1099-DA.
Taxpayers often use different special identification methods, determining costs after the sale rather than before the sale. But if the foreign currency taxpayer chooses separate identification and files using FIFO, reconciliation becomes an insurmountable problem. This discrepancy can result in double counting or a missing cost basis because both parties use incompatible methods to calculate it.
To resolve these complexities, contributors must track spending for each wallet, exchange, and asset. Given the complexity, using dedicated crypto tax software has become not only an advantage, but a necessity.
Gross income: a mixed measure
The term "gross proceeds" on IRS Form 1099-DA refers to gross sales proceeds generated by an exchange, wallet, or other brokerage service. It does not take into account capital gains or losses.
Let's take an example where you sold $75,000 worth of cryptocurrency on Coinbase in one year. If your initial investment in Kraken is $150,000 and no additional information is exchanged, you will essentially suffer a financial loss. Form 1099-DA will only show the $75,000 you sold, giving a false impression of taxable income.
How intermediaries and taxpayers should prepare
Intermediaries should invest in robust systems capable of generating accurate reporting, including sharing cost-based data with other platforms. They should also be prepared with necessary details such as name, address, income, transaction ID and wallet address they provide.
Taxpayers should consider using dedicated cryptocurrency tax software to reconcile Form 1099-DA information with their actual transactions, especially if they use multiple platforms or make wire transfers. The first thing the IRS wants during an audit is a portfolio inventory. It is important to keep a close eye on your portfolio portfolio.
While regulation is an inevitable and necessary step for the maturing cryptocurrency industry, Form 1099-DA is, so to speak, a minefield of complications and pitfalls. All stakeholders must understand these challenges and prepare accordingly to avoid getting lost in a budget maze with no easy way out.