Outdated IRS Guidance No Match for Trillion Dollar Crypto Industry

Although the Biden administration recently announced that the IRS will be getting more resources to go after tax evasion, particularly in the new world of cryptocurrency, frustration is mounting at the lack of crypto guidance being given to American taxpayers during a record-breaking bull market. 

One can’t be sure if they are paying the right amount of taxes, or even know if they are evading taxes, if they are dealing with antiquated IRS guidance that dates back to 2014.

“It’s tough because there’s only been one IRS notice that was ever released specifically for cryptocurrency,” Harness Tax Manager Sam Boehr told Blockworks. 

The IRS issued that guidance in 2014, when Ethereum was somewhere between a powerpoint deck and an early beta and bitcoin hovered around $450-$700. In the seven years since, digital assets have grown to a market cap of $1.9 billion, according to CoinGecko.

Despite the massive changes over the last seven years, the IRS has only updated an FAQ section to that 2014 notice. “That is the only guidance the IRS has given from their official standpoint. They haven’t codified anything with regards to digital assets,” he said.

In an effort to update its ability to tax digital assets despite the lack of internal guidance and probably skill sets, the IRS recently announced that it is partnering with a firm called TaxBit to ensure crypto-compliance. TaxBit allows users to upload data from their wallet or exchange to the platform, and it calculates the taxable position after factoring in other deductions. 

The partnership could be first step, but complexity and confusion still reign.

Property tax?

First, the IRS has been pushing towards treating digital assets as property. Boehr explains that this means capital gains taxes, which can be for the most part straightforward. If you’re an active trader, it’s likely going to mean that things are classified as “ordinary income” and taxed accordingly. 

The IRS 2014 guidance gets even more outdated when it comes to recent and sometimes profitable trends like staking (locking in crypto for a specific amount of time and earning yield) or mining. These are both considered a “job”. As a result, when the resulting crypto is sold, it becomes a capital gains or capital loss scenario.   

“In this gray area, the IRS would probably side that [crypto earnings are] an asset that’s considered property and they would approach it as a capital gain,” he said. 

The international angle 

Where it gets tricky is when digital assets trading takes an international angle. Many of the popular exchanges are located offshore. Servers that execute the trades and store a copy of your wallet and its keys are located in foreign jurisdictions. This adds a new level of complexity.

“When it comes to domestic versus foreign investments, the foreign side can get tricky based on where the assets are,” he said. “Individuals may not know that they have to do a foreign bank account reporting requirement to the IRS if their foreign investments were worth over $10,000 in value at any time throughout the year. That may be one aspect to this that individuals are maybe overlooking.”

Today, the penalty for not declaring a foreign bank account is $10,000 per account. 

Another complex issue on the horizon: are users that trade on a server in a specific offshore jurisdiction liable for taxes in that said jurisdiction; and what about decentralized exchanges (DEXs), that fly no flag?

In a sign of how new some of these questions are, Boehr said, “I’ve never had to advise a client on a DEX, because they are that new.”

DeFi’s big boom only came during 2020 so it might be something that gets accounted for in later tax years.

Collecting data to tax the trader

Boehr believes that uniform third-party reporting by exchanges is the missing link.

However, this is starting to change. Coinbase began issuing 1099 forms used to declare income that does not come from salaried employment, and reporting data on large volume traders to the IRS.

Coinbase rival Kraken was recently subpoenaed by the IRS to hand over information on any “John Doe” with over $20,000 in transaction volume. Kraken pushed back, but was ordered by the court to hand over data which the IRS will use to match against tax filings.

“I feel like that the lack of third-party reporting is probably the biggest hindrance right now for [the IRS] to do a proper accounting of who was making what,” he said. “It’s kind of like doing a tax return… I’m going to tell you how much I owe in tax, but you’re going to tell me if I’m wrong or not.”

Still, many of these exchanges aren’t US-based and are thus out of the reach of the IRS and its reporting mandates. “Is the IRS ever going to find out about this? Probably not, until bigger amounts of income get repatriated into your bank account,” Boehr said.

Claiming a capital loss

History hasn’t yet decided if May 19, 2021, would be a day that lives in crypto infamy, but data provider ByBt has run the numbers. Liquidations totaled $8 billion. 

For traders, Boehr explained that if your capital losses exceed your capital gains you’re only allowed to take up to $3,000 of that loss to offset your ordinary income. Of course for more sophisticated investors there’s a whole area of complicated  harvesting of losses to offset gains in other areas. 

But for salarymen with a W2, $3,000 of losses per year is the limit. This carries over into the future against income until the amount lost is exhausted, but given the number of people that got ‘rekt’, recovery is going to take a while.