The U.S. Infrastructure and Jobs Act ushered in “broker reporting” rules for centralized crypto exchanges, effectively turning digital assets into securities for purposes of the Section 6045 reporting requirement. Stock trading firms issue tax forms 1099-Bs with sales of securities and capital gains and losses, so centralized exchanges will do the same thing for crypto trades on the new Form 1099-DA. Cash App and Robinhood Crypto, for example, have already been issuing crypto trades on 1099-Bs for several years.
This article is part of CoinDesk's Tax Guide 2023. Kirk Phillips is an entrepreneur, Certified Public Accountant (CPA) and author of "The Ultimate Bitcoin Business Guide: For Entrepreneurs & Business Advisors."
At first glance it might seem like crypto reporting by exchanges means less work for the taxpayer, but it’s the opposite. This creates a huge burden for centralized exchanges and saddles the taxpayer with a more onerous crypto tax reporting exercise. Taxpayers in other regimes that implement similar rules will suffer the same fate.
Let’s dig deeper and find out why.
The voluntary system and information reporting
The U.S. has a voluntary tax compliance system where the taxpayer is responsible for calculating and filing their own taxes. Taxpayers report two kinds of information:
- Third-party reported information
- Self-reported information
The Internal Revenue Service matches amounts reported by third parties to make sure they’re the same amounts reported by the taxpayer. Third-party tax forms include W-2s, 1099s, 1098s and so on. Taxpayers self-report any income, expenses or deductions not reported on third-party forms. Both of those reporting methods were completely separate until now.
Crypto tax calculations were mostly the 100% self-reported variety, but the new broker reporting rules relegate taxpayers to a combination of third-party and self-reporting, and that’s where the problem begins. Taxpayers will still manage their entire view of crypto tax calculations. Meanwhile, multiple exchanges will report their tiny view of a taxpayer’s crypto landscape, leaving the taxpayer to piece together 1099-DAs and figure out whether they’re correct.
What’s been described in these pages as “The Maddening Task of Calculating Crypto Taxes” is the first clue the new reporting rules will create more crypto tax headaches, not less. Taxpayers can easily rack up five to 10 times more wallets and exchange accounts than stock trading and bank accounts while having to untangle a web of crypto transactions contained within.
Reporting and reconciling pitfalls
Most crypto tax software providers deployed the universal cost basis feature that dumps all transactions into a single bucket for calculation purposes. Alice (not her real name!) has been in crypto for six years and accumulated seven exchange accounts and 13 wallets. The software commingles all her transactions from 2018 up to the current year and makes one calculation as if Alice was only using one wallet.
Under the new rules, Alice would receive seven 1099-DAs in addition to her own universal calculation. Alice is no longer solely responsible for her crypto tax calculations and instead has eight parties, including herself, in on the calculation exercise.
Alice has been calculating and self-reporting her crypto taxes on Form 8949 for years. She disregards the seven 1099-DAs because she’s already included all her transactions in the current Form 8949. Alice files her tax return as usual and gets flustered after receiving an IRS notice saying she underreported income. Now Alice must amend her tax return and report the information as received on the 1099-DAs.
Bob, on the other hand, has eight wallets and four exchange accounts. He reported four 1099-DAs on his tax return and deleted the transactions for those four exchanges from his crypto tax software. Bob thought this was a clever solution to avoid double-counting his exchange transactions, but he didn’t realize two of the exchanges didn’t report cost basis on 1099-DAs. As a result, he overstated his capital gains and significantly overpaid more tax than he should have.
Bob and Alice have run headfirst into some of the numerous 1099-DA pitfalls. Now they must go through a rigorous exercise to reconcile all the 1099-DAs with their own universal calculation to double-check the exchanges correctly reported information. The challenge of managing crypto taxes just got magnified. In the absence of a thorough reconciliation and cross-checking exercise, taxpayers will otherwise double count and/or omit cost basis and therefore understate or overstate tax liabilities. Let’s look at some other 1099-DA pitfalls.
Cost basis gotchas
U.S. taxpayers can use FIFO, first in first out, or specific identification for crypto cost-basis methods just like securities sales. FIFO is simply a tracking method where the oldest crypto purchased is considered the first crypto sold and specific identification allows taxpayers to choose a specific batch of crypto to sell before selling it.
In legacy finance, a taxpayer can give notice to their securities broker to use specific identification and then instruct the broker which tax lot of securities to sell. Specific identification doesn’t work this way in crypto because both exchanges and crypto tax software don’t provide any pre-sale identifying mechanisms. This means exchanges will default to providing FIFO-only cost basis on 1099-DAs.
Meanwhile, taxpayers use several cost method methods, numerous other ways crypto is considered sold for tax purposes, as proxies for specific identification because the cost basis in the calculation is “identified” after the sale instead of before. Nonetheless, if exchanges report on a FIFO basis and the taxpayer uses specific identification, then reconciling between the two will be impossible. This illustrates how cost basis would be double counted and/or omitted because the taxpayers and exchanges are using inconsistent cost basis methods.
Cost-basis tracking on a per-wallet and exchange basis would help the reconciliation process but doesn’t come without its own issues. Several crypto tax software providers, such as Cointracker and Bitwave, are rolling out per-wallet and exchange tracking and some already had these features.
Alice has consistently used the FIFO cost basis method and wants to reconcile her 1099-DAs so she switches her crypto software from universal to per-wallet tracking. She’s surprised to get different gains and losses for each tax year, but her new CPA explains the calculations go back to 2018 and the per-wallet method is recalculating what has already been calculated in prior years. Crypto software must lock down cost basis at the end of 2022, for example, so the shift to per wallet tracking avoids the double-counting and/or omissions dilemma.
How to avoid future Issues
It’s unclear how exchanges are going to manage customer basis and data tracking because 1099-DA reporting is currently deferred until final regulations are issued. One thing is clear, though – there will be differences and taxpayers will have extra work to correctly adjust gains and losses on their tax returns. Form 8949, used to report the detail all crypto trades, has adjustment codes to deal with incorrectly reported basis and other issues. However, this is easier said than done. In addition to the normal crypto tax headaches, taxpayers must track 1099-DA reconciliation differences, calculate adjustments and figure out reporting so final gains and losses are correct. There are also many other issues too numerous to mention here.
Bob, a decentralized finance (DeFi) degen, wants to avoid the 1099-DA conundrums and decided to use his centralized exchanges as stablecoin-only on- and off-ramps and use DeFi protocols for all his other crypto activity. His 1099-DAs would only show stablecoin sales with gains and losses essentially zero, thus eliminating the reconciliation and adjustment exercise. Bob is going to minimize transfers among exchanges to keep activity as self-contained as possible. He’s also considering opening new exchange accounts to containerize new trades and cost basis when 1099-DAs are finally issued.
We need crypto tax management to get easier, not harder. The ideal compromise for final broker reporting rules would be removing the cost basis reporting requirement to eliminate most of the cost basis reconciliation headaches. Then taxpayers would only have to deal with reconciling reported proceeds from trades.
Fortunately, the delay with 1099-DA will give more time for exchanges to develop better reporting, crypto tax software providers to develop more useful tracking features and taxpayers to strategize ways to minimize headaches. The IRS will be seeking public comments on proposed regulations to implement the broker reporting rules per Announcement 2023-2. Voice your opinion and contribute comments.