After the Industry’s Brutal 2022, What’s Ahead for Crypto Tax Compliance?

Whether taxpayers are expecting refunds or making tax payments, most are relieved to wrap up an uneventful, no-surprises tax filing season. After all, this is the first “normal” tax season in recent years — most tax-related pandemic relief measures have been phased out, and the IRS has committed substantially more resources to ensure better taxpayer experiences following complaints of long waits in prior years.[1]

This filing season has also seen relatively less media attention paid to cryptocurrency tax reporting. This has a lot to do with the reduced valuation of crypto assets; the estimated market capitalization for cryptocurrencies decreased by over 50% in 2022.[2] The lack of news coverage may be sending a misleading signal to onlookers that cryptocurrency taxation is no longer a priority policy area. However, the Treasury Department listed the taxation of transactions involving digital assets and associated information reporting in its 2022-2023 Priority Guidance Plan, suggesting that the agency still intends to give tax issues associated with cryptocurrency significant consideration.[3]

This issue brief summarizes several recent developments and upcoming trends in cryptocurrency tax compliance, including requirements for broker reporting on digital assets, the evolution of digital asset questions on Form 1040, and the application of wash-sale rules to digital assets in President Joe Biden’s most recent budget proposal. Ultimately, more reporting rules are on the horizon, but new IRS guidance will provide welcome clarity for taxpayers.

The Impending Broker Reporting Requirement

Three years ago, former IRS Commissioner Charles Rettig testified that the lightly regulated cryptocurrency sector was a major contributor to the rapid growth of tax underreporting and requested authority from Congress to collect information related to crypto transactions.[4] Since then, the crypto market downturn and drop in transactions have largely diverted public attention from tax compliance, along with a series of crypto firm failures — including the high-profile collapses of FTX and BlockFi — that exposed the industry’s lack of transparency. These catastrophes did, however, revive regulatory attention.[5]

The Infrastructure Investment and Jobs Act (IIJA) passed in November 2021 includes a provision, originally set to come into effect earlier this year, that will require cryptocurrency brokers to report digital asset transactions to the IRS.[6] The Joint Committee on Taxation estimates the requirement will raise approximately $28 billion over a 10-year period.[7]

Generally, brokers are required to file information returns (Form 1099-B) with the IRS and provide copies to their customers, including gross proceeds and bases for assets sold. Prior to the passage of the infrastructure bill, the regulations did not specifically address how broker reporting requirements applied to digital assets. They also did not explicitly subject digital assets to basis reporting (the price of acquiring an asset, used to calculate capital gains).

The IIJA essentially expanded the definition of “broker” to include “anyone who is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” It also clarified that digital assets are covered under broker reporting requirements.

Some industry participants have expressed concern that the law’s definition of a broker is overly wide. These critics claim that based on the letter of the law, individuals who are involved in digital asset transfer services from a technical standpoint but have no access to transactional or financial information could be subject to these reporting requirements. The Treasury has subsequently stated it does not intend to subject developers, miners, stakers, or software sellers to the reporting rule.[8]

In late December 2022, the IRS issued transitional guidance on the IIJA’s cryptocurrency broker reporting requirements, essentially delaying their effective date for at least a year.[9] In other words, brokers are not required to report additional information on digital asset-related transactions until the final rules are released.

Although the rules’ effective date is postponed, the issue of cryptocurrency tax reporting is not less important. High cryptocurrency price environments highlight concerns with tax underreporting and revenue loss, while declines in cryptocurrency prices turn the focus to taxpayer protection and the safeguarding of capital market functionality. In both circumstances, transparency is crucial, and information reporting is instrumental in achieving it.

The Evolution of Form 1040 Reporting

The IRS has been modifying the cryptocurrency reporting mechanism over the past four years. In 2019, the agency included a question on Schedule 1 of Form 1040 asking taxpayers for the first time if they had received, sold, sent, exchanged, or otherwise acquired any financial interest in virtual currency during the year. In 2020, this question was moved from an attached schedule to the front and center of Form 1040. In 2021, the question became: “Did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” This modification shows that the IRS is narrowing its inquiry to taxable events. On its FAQ web page, the agency clarified that taxpayers who only purchased cryptocurrency with cash and did not dispose of any cryptocurrency can answer no to the question.[10]

For the 2022 tax year, the question has been further refined to: “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”[11] This change makes clear that digital asset reporting is not limited to cryptocurrency, but also applies to any digital representation of value, consistent with the infrastructure bill’s definition of “digital asset.”[12]

The question also reminds taxpayers that in addition to trading cryptocurrency, receiving cryptocurrency as compensation and using cryptocurrency as payment both trigger taxable events. For the former case, recipients are to recognize ordinary income whether they are an employee or independent contractor. The compensation is subject to self-employment tax for independent contractors and to withholding tax for employees — including the Federal Insurance Contributions Act (FICA) tax and the Federal Unemployment Tax Act (FUTA) tax — like other wage income. Finally, a taxpayer who receives cryptocurrency as compensation will trigger a realization event for capital gains taxes whenever the cryptocurrency is converted to cash or used for payment.

The capital gains (or losses) from the use of cryptocurrency as payment are calculated as the difference between the fair market value of the services or goods received and the cryptocurrency tax basis. The tax basis is the fair market value of the cryptocurrency on the day the taxpayer received it.[13] The taxpayer then applies the appropriate capital gains tax rate (which depends on the taxpayer’s income level and holding period) to the capital gains in order to come up with the tax liability.[14] 

Beyond these situations, most cryptocurrency holders participate in the market as investors. These taxpayers need to have records of tax cost basis and fair market value, and they must determine whether their capital gains or losses are long term or short term. Most commonly, the cost basis of cryptocurrency is the price paid to acquire it on an established exchange, including fees and commissions. Taxpayers can also obtain fair market value from the exchange when they sell their tokens, or individual units of cryptocurrency; the difference between the amount received at disposal and the tax basis will constitute the gains or losses.[15]

Cryptocurrency investors are more likely to have capital losses than gains for the 2022 tax year. Similar to gains or losses in stock trading, taxpayers can offset capital losses from cryptocurrency transactions with gains from selling appreciated real estate, business interests, or other securities. If the losses exceed the gains for a particular year, taxpayers can deduct up to $3,000 of such losses against other income (e.g., wages and salary) and carry forward the balance to offset future capital gains. However, despite the collapse of several large crypto exchanges and plunge in value of associated cryptocurrencies, taxpayers cannot declare losses unless they demonstrate them by selling the tokens.[16] The IRS guidance states that although these cryptocurrencies have sustained a substantial decline in prices, they still have value. Accordingly, since the cryptocurrencies are not considered worthless, taxpayers cannot claim tax losses unless they dispose of the assets.[17]

Taxpayers who would like to properly capture the tax benefits associated with their losses (commonly known as “loss harvesting”) from 2022 will need to come forward and provide information on taxable transactions to the IRS. As such, although the delay of the cryptocurrency broker reporting requirement may seem like a setback for cryptocurrency tax compliance, many taxpayers still have incentives to report voluntarily this tax season.

Wash-sale Rules

Biden’s budget for fiscal year 2024 includes a cryptocurrency-related tax provision. In particular, the budget calls for applying wash-sale rules to digital assets, including cryptocurrency. This provision is expected to generate $9 billion between fiscal years 2024 and 2028, or $23.5 billion over 10 years.[18] 

The wash-sale rules essentially state that a taxpayer who sells an investment at a loss but turns around and buys the same investment (or a substantially identical one) within 30 calendar days before or after the sale will be unable to claim the loss on that year’s federal individual income tax return. At present, this rule applies to securities including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and options, but not explicitly to cryptocurrencies or other digital assets.

Many practitioners and lawmakers have noted that the lack of wash-sale rules for digital asset transactions presents a loophole and have argued that similar rules should apply to digital assets.[19] Without wash-sale rules, cryptocurrency investors can sell digital assets at a loss, gather tax breaks, and immediately repurchase the same cryptocurrencies. 

While many provisions in the president’s budget have only a narrow chance of becoming law, the digital asset wash-sale rule is one of the few with bipartisan support. In general, critics find it unfair that cryptocurrency enjoys more favorable tax treatment than other kinds of investments, such as stocks and bonds.

Conclusion

Despite the steep decline in cryptocurrency valuation in 2022, tax compliance remains a critical topic for the purposes of taxpayer protection and broader governance. The Treasury is expected to issue additional guidance in the coming months for broker reporting rules, and lawmakers from both parties are currently gathering support to apply the wash-sale rules to digital assets. In addition, the IRS will carry on refining the reporting mechanism on Form 1040 and collecting more information about cryptocurrency transactions.

The future will bring more digital currency reporting requirements, but also more regulatory guidance and clarity. For taxpayers, keeping comprehensive records and staying on top of IRS guidance continues to be the best policy.  

Endnotes

---

[1] Alexis Christoforous, “Taxpayers Could See 1st ‘Normal Filing Season’ in Years,” ABC News, March 12, 2023, https://bit.ly/3KdwmVg.

[2] CoinMarketCap, “Global Cryptocurrency Charts: Total Cryptocurrency Market Cap,” accessed November 30, 2022, https://coinmarketcap.com/charts/. 

[3] Department of Treasury, 2022-2023 Priority Guidance Plan, November 4, 2022, https://bit.ly/3TOzsCv .

[4] David Lawder, “U.S. IRS Chief Asks Congress for Authority to Collect Cryptocurrency Transfer Data,” Reuters, June 8, 2021, http://bit.ly/3LZkS9f.

[5] Patricia Kowsmann and Caitlin Ostroff, “Crypto Giant Binance Offers Little Transparency After FTX Collapse,” Wall Street Journal, December 21, 2022, http://bit.ly/3FYTV1F.

[6] Infrastructure Investment and Jobs Act, Public Law No 117-58, U.S. Congress, November 15, 2021, https://www.congress.gov/bill/117th-congress/house-bill/3684. See Section 80603.

[7] Joint Committee on Taxation, “Estimated Revenue Effects of the Provisions in Division H of an Amendment in the Nature of a Substitute to H.R. 3684,” JCX 33-21, August 2, 2021, https://bit.ly/3zjRO4A.

[8] Miners are those who verify cryptocurrency transactions and create new tokens, or individual units of cryptocurrency. Stakers earn rewards for holding certain cryptocurrencies.

[9] IRS, “Transitional Guidance under Sections 6045 and 6045A with respect to the Reporting of Information on Digital Assets by Brokers,” Announcement 2023-2, December 23, 2022, https://bit.ly/3TOAFJX.

[10] IRS, “Frequently Asked Questions on Virtual Currency Transactions,” last updated January 13, 2023, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions. See FAQ no. 5.

[11] IRS, “Form 1040 for Taxable Year 2022,” accessed March 14, 2023, https://bit.ly/3KfmiuS.

[12] Section 80603(b)(1)(B) of the infrastructure bill (Public Law No 117-58) defines a “digital asset” as any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary, except as otherwise provided by the Secretary.

[13] IRS, Frequently Asked Questions on Virtual Currency Transactions (FAQ no. 9-13).

[14] IRS, Frequently Asked Questions on Virtual Currency Transactions (FAQ no. 14-15).

[15] IRS, Frequently Asked Questions on Virtual Currency Transactions (FAQ no. 6-8).

[16] Lauren Vella, “Crypto Bankruptcies Leave Taxpayers in Limbo in Filing Season,” Bloomberg Law, February 21, 2023, https://news.bloombergtax.com/daily-tax-report/crypto-bankruptcies-leave-taxpayers-in-limbo-in-filing-season.

[17] IRS, “Office of Chief Counsel Memorandum – Number 202302011,” January 13, 2023, https://bit.ly/3M6Y9YK.

[18] The White House, “Budget of the U.S. Government: Fiscal Year 2024,” Office of Management and Budget, March 9, 2023, https://bit.ly/3TT4Nnx.

[19] Samantha Handler, “Close Crypto Tax Loophole to Raise Revenue, Senators Say,” Bloomberg Law, February 21, 2023, https://news.bloombergtax.com/daily-tax-report/close-crypto-tax-loophole-to-raise-revenue-senators-say.

 

 

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.