Don't Get Tax Rekt: Sail Your Crypto Ship into IRS Safe Harbor Before the December 31, 2024 Deadline
Nov 22, 2024Sail your crypto ship into the “safe harbor” or get rekt at sea. That’s the metaphor for the ONE-TIME cost basis exercise for US taxpayers that MUST be completed by December 31, 2024. I suspect a majority of taxpayers will miss this boat entirely because they didn’t get the message or don’t understand the impact. I’ll break this down one more time.
Let’s start with two blogs in which I previously posted about the new IRS digital asset guidance:
- Final IRS Broker Regs: New Insights (Making sense of the new IRS guidance on crypto)
- What You Need to Know About Rev. Proc. 2024-28
Key Takeaway
US Taxpayers have until December 31, 2024 to make a one-time cost basis allocation to sail into the safe harbor and out of the stormy seas of the IRS.
Why do I need to allocate?
The universal cost basis tracking used by all crypto tax software since the beginning of time is no longer allowed for US taxpayers. All crypto cost basis MUST be tracked on an account-by-account and exchange-by-exchange basis, starting January 1, 2025. The death of universal cost basis means crypto tax management goes from painful to worse and triples the cost of crypto tax prep.
Two allocation methods
1. Specific unit allocation (the "choose your own adventure" method)
Think of this as playing Tetris with your crypto! You get to be the boss and decide which cost basis blocks go where in your wallets. Just remember to include when you bought it and how much you paid. But here's the kicker: You've got until October 15, 2026, extended deadline to get this done, as long as you don't touch your crypto before allocation.
2. Global allocation (the "set it and forget it" method)
This is like setting up crypto autopilot! Pick your rule (maybe "oldest coins first" or "cheapest ones first"), and let it roll. But once 2025 hits, no takebacks. You're locked into whatever rule you chose. It's like setting up a crypto playlist and hitting shuffle - you've got to trust the process.
Key Takeaway
Don’t defer the allocation process under the specific unit allocation. Complete this before January 1, 2025. If you forget and make one crypto transaction you’ve blown the safe harbor.
What happens if I don't allocate?
You don't get the "safe harbor" which is like a free pass from penalties, interest or recalculation of your current and prior year's taxes (potentially). It's possible you could get "tax rekt" if you don't allocate.
EXAMPLE
Follow this "Cost Allocation Proof," which helps understand the following steps to allocate.
How do I allocate?
- Stop all buy, sell, transfer and other crypto activity while you're in the process. Otherwise, you create a moving target. For example, you may need to pause your crypto from December 15th to December 31st.
- Export a year-end balances report from your crypto tax software. You should consider doing this now just to get familiar with what you need to allocate. Only use the export file to allocate after you stopped your crypto activity.
- You need to export the year-end balances as close to the end of 2024 as possible. It will likely take some time to complete the process based on the complexity of your crypto.
- Some crypto tax software like cointracker, for example, implemented a wallet-by-wallet feature in 2023. This may help facilitate the process and essentially allocate for you. The export procedure from #2 and #3 above should still be followed to document this was done on or before December 31, 2024.
- The end of year balance report is like a universal list of all your current crypto holdings. All of your cost basis needs to be allocated to each of your wallets and exchanges. The example Excel proof file shows an example with check totals to "prove" all the cost basis has been allocated.
- When you're done with the spreadsheet, email it to yourself so you have timestamp proof.
What are the challenges?
- You can do a manual in a CSV or Excel file, but the trick is getting the crypto tax software to match, which is virtually impossible because the software was not designed with the kind of tooling (generally speaking).
- The best way to simplify the process and make it less complicated is to:
- Consolidate all your BTC, for example, into a single wallet and same for all your other crypto. Do this as practically as possible.
- Remove LP positions and similar complex crypto stuff because crypto tax software generally does NOT track these things well for cost basis .
- Remove ALL crypto from centralized exchanges (CEX) to cleanse the cost basis. When you send crypto back to the exchange it will assign a zero cost basis. (This is far better than having the wrong cost basis)
PITFALL
CEX basis will never match the basis you have been tracking. This is a perpetual mismatch conundrum.
If you can get 37 wallet and exchange accounts down to seven, then you're way ahead of the game. Hopefully, the software will match what is in your wallets so do a cross-check and document any differences, The fewer wallets, the better the result.
- Download a year end balance report after the consolidation exercise is complete to your satisfaction. Then allocate and document.
- The Excel allocation should be done as proof you allocated and to get the safe harbor.
What do I need to know in 2025 after the safe harbor?
As I’ve pointed out in What You Need to Know About Rev. Proc. 2024-28, only two cost basis are permissible: FIFO and specific identification.
Key Takeaway
Specific identification is a cost basis method and the specific units allocation is a one time allocation method so it’s easy to get confused. Although they both sound similar there is no relation.
Choose FIFO or specific identification
After the allocation is done, taxpayers can choose either FIFO (first in first out) cost basis method, the “default method” or Spec ID (specific identification). This should make sense because we’ve been talking about this for a while and these two methods already applied before January 1, 2025, and will still apply after December 31, 2024.
- FIFO: Requires no work by the taxpayers when selling digital assets. The oldest digital assets are always “sold” first so brokers and tax software should have no issues here. The tradeoff is taxpayers have no ability to control gains and losses.
- Spec ID: Gives taxpayers the ability to choose what gains and losses to trigger and when. This can make a big difference in your tax bill and is more desirable at first glance. The tradeoff is taxpayers must identify the tranche, tax lot, or batch of crypto they want to sell before they sell it.
PITFALL
It’s practically impossible to follow Spec ID to the letter of the law. Crypto tax software generally does not provide the ability to pre-identify the cost basis of your desired trade to match what actually happens (although a few are working on it). Centralized exchanges (digital asset brokers) have the same problem because they do not provide a way for taxpayers to instruct the broker about which lot to sell.
Key Takeaway
Taxpayers have a unique opportunity to shift from Spec ID (or HIFO, CCFO or other cost basis methods offered by crypto tax software) to FIFO after completing the one-time cost basis allocation. You can avoid the Spec ID conundrum but forgo any control with gains and losses. It’s your choice. If you stay with Spec ID, then email the trade to yourself before you make the trade. (Ridiculous I know.)
EXAMPLE
Bob Smith wants to sell 3.4 ETH with the highest cost basis from his MetaMask account called “BS ETH MetaMask 2-17-20” so he emails himself the same info to document Spec ID BEFORE he makes the trade. Bob prays the HIFO (highest in first out) cost basis method in his crypto tax software settings matches his intentions.
Resources
- The IRS Rev Proc 2024-28.
- AICPA Comment Letter on Rev Proc 2024-28.
- Listen to the AICPA Tax Odyssey podcast where I explain the Rev Proc 2024-28 gotchas.
Good luck on the allocation.
As always, your goal is to get a Crypto Bullseye™.
Yours in crypto,
