Crypto once again doesn’t fit into the regulatory round hole. The proposed 6045 digital asset broker regulations – currently in a comment period – are filled with problematic requirements. A few of them make taxpayer compliance impossible.
Digital asset brokers must report proceeds and cost-basis on a proposed Form 1099-DA information return like a 1099-B but for digital assets. The complexity of cost-basis reporting creates multiple issues for both brokers and taxpayers creating even more work for the already daunting task of calculating crypto taxes.
Choice of cost basis
The proposed regs clarify taxpayers have two cost basis choices:
- FIFO: The default method deems the oldest purchases as sold first.
- Specific Identification: The taxpayer chooses which digital assets to sell.
Many people in crypto are familiar with FIFO and have already been using it for tax calculations. If taxpayers do not choose FIFO, they get relegated to a “specific identification” where most of the cost-basis issues arise for digital assets.
Specific identification requirements
Taxpayers are responsible for specifically identifying the units of digital assets sold no later than the date and time of the sale, disposition, or transfer regardless of whether a broker is used.
Specific identification must happen before-the-trade NOT after the trade. Taxpayers must dig through their records and mark the specific BTC (or other asset) in their “crypto inventory” they intend to sell. Then the taxpayer makes a trade and repeats the process in a time intensive exercise.
The IRS states, “A specific identification of the units of a digital asset sold, disposed of, or transferred is made if, no later than the date and time of the sale, disposition, or transfer, the taxpayer identifies on its books and records the particular units to be sold…”
If a taxpayer uses a broker they must instruct the broker which digital assets they intend to sell before-the-trade. In the case of a broker taxpayers must:
- Identify and document digital assets in their own records
- Tell the broker to sell the assets they’ve identified
The IRS states, “…the taxpayer specifies to the broker having custody of the digital assets the particular units of the digital asset to be sold…”
Now, if you don’t meet the spec id requirements, your basis defaults to FIFO and you could incur a gigantic tax liability. Your spec ID gets recalculated under a FIFO basis.
Impossible to notify
These rules apply to securities sales, so there is no surprise to the logic. However, crypto neither operates like legacy finance nor fits into the proposed reporting regime.
Read more: Crypto Tax Basics: A 101 for Beginners
Let’s start with the broker notification requirement. Centralized exchanges like Coinbase and Kraken don’t provide a notification mechanism to support specific identification. This leaves taxpayers with no way to instruct the exchange to sell a specific lot of, say, bitcoin.
If the exchange doesn’t support specific identification, they will default to FIFO reporting for all their customers. Meanwhile, taxpayers who previously used HIFO (highest in, first out), CCFO (closest cost, first out) or some other cost-basis method in prior years end up with a perpetual cost-basis mismatch. The exchange issues a 1099-DA on a FIFO basis and taxpayer A calculates a totally different gain or loss using their own cost-basis method. You should start to see where the extra work is creeping in.
If it’s impossible for taxpayers to instruct brokers, then it’s impossible for taxpayers to comply with this rule. Even if taxpayers could notify brokers, they still need to have a system to track and report 1099-DAs on a specific identification basis.
This creates two problems for taxpayers:
- How are taxpayers expected to reconcile between the 1099-DA and their own calculations?
- If taxpayers can even figure out the difference, how do they report differences on their tax return and explain the issue?
Impossible to calculate
Crypto tax software providers typically include FIFO and one or more other cost-basis methods such as HIFO and CCFO in the software settings. Taxpayers have previously used these non-FIFO methods as a proxy for specific identification as the software is not designed for taxpayers to identify digital assets before-the-trade. All these cost-basis choices including FIFO are a logic methodology that calculate gains and losses after-the-trade.
It’s practically impossible to calculate crypto taxes without the aid of crypto tax software, yet even if the taxpayer marks their records to indicate specific digital assets they intend to sell, the software can’t incorporate those digital assets into gain and loss calculations. Taxpayers are stuck with one of the logical cost-basis methods and they have to export their current crypto holdings into a CSV file to manually mark records outside of the software.
If it’s impossible for taxpayers to calculate crypto tax without software and the software can’t support specific identification, then it’s impossible for taxpayers to comply.
Why is this a problem for taxpayers?
If taxpayers can’t meet the specific identification requirements, their cost basis method defaults to FIFO resulting in a recalculation of gains and losses. Then taxpayers could incur a gigantic tax liability including significant interest and penalties (which is headache #1).
The difference between FIFO and other methods can be night-and-day, which is the reason taxpayers used a method other than FIFO in the first place. For example, Taxpayer A bought ETH in the 2014 crowdsale and FIFO would “sell” the old ETH every time they make an ETH trade. Naturally, Taxpayer A opted to use a non-FIFO method to minimize gains.
Meanwhile, taxpayer B has seven exchange accounts and 29 wallets for a total of 36. Before the proposed regs, Taxpayer B was 100% responsible for calculating his own crypto taxes. He gathered all transactions together from all exchanges and wallets into crypto tax software to produce Form 8949 for gains and losses on a universal basis. Universal means all transactions are dumped together for calculation purposes “as-if” they happened on a single exchange.
Taxpayer B must now track and calculate gains on an exchange-by-exchange and address-by-address basis. After the proposed regs, Taxpayer B will get at least 36 1099-DAs and end up reconciling them with his own calculations. Instead of having one universal calculation, he now has 36 separate calculations. It’s likely every one of the 36 1099-DAs is different from B’s calculation from various cost basis issues. The IRS just doubled, tripled or even quadrupled your tax prep cost as a result.
Even if brokers and crypto tax software providers change to a specific identification friendly process it doesn’t magically make all the problems disappear. The IRS should listen to the thousands of comments, eliminate 1099-DA cost basis reporting and change to “proceeds only” reporting which would solve most of the headaches.
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