The IRS Tripled Your Crypto Tax Prep Cost (The IRS Kills Crypto Part 3)
Oct 25, 2023I previously explained how The IRS Kills Crypto in 282 Page Regs Part 1 and how The IRS Kills DeFi in 282 Page Regs Part 2.
Clarifying crypto cost basis
The IRS proposed regs titled, “Gross Proceeds and Basis Reporting by Brokers and Determination of Amount Realized and Basis for Digital Asset Transactions” will double, triple or even quadruple your crypto tax prep cost and create a gigantic headache. This deep dive will finally make it very clear.
Understanding the intricacies of cost basis in the IRS world of crypto can be a complex journey. Proposed Section §1.1012-1 Basis of Property, explains how taxpayers must go about specifically identifying digital assets they intend to sell:
“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, disposed of, or transferred by reference to any identifier, such as purchase date and time or the purchase price for the unit, that is sufficient to identify the units sold, disposed of, or transferred in order to determine the basis and holding period of such units”
Key Takeaway
Spec ID means you must identify the digital assets you want to sell BEFORE you sell them NOT after the fact.
There are 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.
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Bob used CCFO for his cost basis
If a taxpayer does not use specific identification, then they must use the FIFO (first in first out) method. If you’ve already been using FIFO then you won’t have to worry about some of the headaches and you’ll have the least amount of work to do. FIFO is going to work in your favor. However, many taxpayers have been using HCFO (highest cost first out) or CCFO (closest cost first out) among many other variations.
Bob has huge built-in gains because he got in early on Bitcoin and Ether. If Bob used FIFO then every subsequent sale effectively “sells” his Bitcoin for a huge gain creating a big tax bill. Bob chose CCFO in 2016 because he knew if would result in smaller gains and lower taxes.
Specific identification requirements
Taxpayers are responsible for specifically identifying the units sold no later than the date and time of the sale, disposition, or transfer under two circumstances:
- Identification of the digital asset NOT in the custody of a broker (unhosted wallet)
- Identification of the digital asset sold at a broker
The IRS explains identification for broker sales as follows, “…the taxpayer specifies to the broker having custody of the digital assets the particular units of the digital asset to be sold, disposed of, or transferred by reference to any identifier, such as purchase date and time or purchase price that the broker designates as sufficiently specific to determine the units transferred in order to determine the basis and holding period of such units…”
Key Takeaway
In the case where the taxpayer sells digital assets with a broker, the taxpayer must tell the broker the specific digital assets they intend to sell. This is in addition, to documenting their own records the same as digital assets in unhosted wallets.
To meet the specific identification requirements, taxpayers need to meticulously notate their digital asset transactions. This involves identifying the units to be sold, disposed of, or transferred by referencing key identifiers, such as the purchase date, time, or purchase price. Bob references his digital assets inventory by downloading a CSV which already lists the information above.
The info already exists for most taxpayers (albeit burdensome as explained later) but the IRS doesn’t state how to mark the records. For example, should Bob color code line items he intends to sell? Should he also put an initial and date next the assets he wants to sell? This type of documentation doesn’t prove he documented anything before the sale.
Non-existent notification
Challenges arise with centralized exchanges like Coinbase and Kraken, which hold digital assets on behalf of taxpayers. They don't offer mechanisms for taxpayers to specify which assets they want to sell. This raises concerns about how taxpayers can comply with broker notification requirements for specific asset sales. Sending support emails might not suffice, and discrepancies in cost basis calculations can emerge, causing headaches for both taxpayers and the IRS.
PITFALL
It’s IMPOSSIBLE for taxpayers to comply with notifying brokers BEFORE-the-TRADE if there is no way to notify them (such that they use the information for reporting purposes)
Bewildered Bob
Bob scratches his head on this one and then decides the best he can do is send an email to [email protected] listing the digital assets he intends to sell. Bob gets a reply that says, “Thanks for the information but we can’t do anything with your request. Our system does not allow us to track specific sales for taxpayers.”
Key Takeaway
Centralized exchanges will default to FIFO reporting because they are currently not designed to receive customer sales requests.
PITFALL
Bob with get a 1099-DA from Coinbase reported on a FIFO basis even though he diligently marked his records or specific sales. Bob will end up with a reporting mismatch, a big headache and no way to solve it.
Challenges with documenting specific identification
Tracking specific identification in records becomes even more challenging when dealing with unhosted wallets. These wallets lack mechanisms for users to specify which digital assets to sell before a transaction occurs. To tackle this complexity, most taxpayers turn to crypto tax software, which aggregates all crypto transactions, provides cost basis calculations, and offers various cost basis methods like FIFO, HIFO (highest in, first out), and more.
In practice, specifically identifying digital assets BEFORE a trade takes place is often impractical due to the sheer complexity of digital asset investments. Unlike securities, crypto investments involve a multitude of exchanges, wallets, tokens, and chains. This complexity makes it challenging for taxpayers to adhere to the specific identification requirements by the sheer amount of work and lack of tools available.
The administrative burden of manually tracking specific identification is cost prohibitive. Taxpayers are forced to download CSV files from their crypto tax software, manually notate the assets they intend to sell, and repeat this process for every trade. Crypto tax software doesn’t have features to calculate and reflect the digital assets identified by the taxpayer.
Wasting more time on documentation
Bob had 837 trades in 2024 and had to download 837 CSV ending position reports from his crypto tax software after each trade so he could identify the next trade. He spent more time documenting trades for compliance purposes then actually investing. Bob thought the IRS was supposed to consider the administrative burden when issuing new tax rules.
Even if taxpayers meticulously document specific identifications, they can’t incorporate this data into crypto tax software. The software generally lacks the features to consider user-specified asset lots for gain and loss calculations. This limitation makes it impossible for taxpayers to calculate gains and losses based on specific identification.
PITFALL
Taxpayers can document spec ID until they are blue in the face. It’s all a waste of time with zero value because there is NO crypto tax software available to identify trades before they happen and then make calculations to match. It’s impossible for taxpayers to comply.
Specific identification by proxy
Taxpayers who aim to calculate their crypto taxes based on specific identification often resort to alternative cost basis methods within crypto tax software. Methods like HIFO and CCFO (closest cost first out) act as proxies for specific identification, as they closely resemble the gains and losses associated with specifically identified assets. Continuing to allow these alternative methods can ease the administrative burden, especially given the limitations of current crypto tax software.
Key Takeaway
The IRS should consider removing the requirement for taxpayers to specifically identify digital assets before a sale, as it often leads to complexities that are impractical to manage. In the end, even with robust 1099-DA reporting, taxpayers must still rely on crypto tax software to reconcile and ensure accurate reporting to the IRS.
The perpetual mismatch
Taxpayers generally used a universal cost basis method provided by crypto tax software. Bob had 7 centralized exchanges, 29 wallets and 2,467 total transactions in 2022. The software commingles all 2,467 transactions together into a “fictitious universal wallet” AS-IF all of them took place on ONE exchange.
Going forward Bob must now track and calculate all his crypto trades on an account-by-account and address-by-address basis. After Bob makes this switch his Coinbase inventory in the software will NOT match the inventory of digital assets Coinbase had on record in Bob’s account.
Key Takeaway
Taxpayers will have perpetual digital asset inventory mismatches between their own records and exchange records with NO way to align the two.
FIFO default and the cost basis mismatch
Furthermore, as explained above centralized exchanges will default to FIFO because they currently don’t provide a mechanism for taxpayers to specifically identify their trades. The exchanges will report on a FIFO basis and taxpayers are still tracking on a specific identification basis resulting in another conundrum.
Bob and his fellow taxpayers end up getting relegated to reconciling every 1099-DA they receive with their own calculations. Are you starting to see the magnitude of the nightmare?
Bob would get 23 1099-DAs from his 7 exchange accounts and 16 DEXs (decentralized exchanges). (The jury is out on whether the DEX will file 1099-DAs) Now Bob has to reconcile every one of his 1099-DAs which likely all differ from his own records. Ouch!
The new crypto tax nightmare
How do you rate crypto tax prep on the nightmare scale from 1 to 10 with 10 being the worst-case scenario? (I already know what the answer is and it’s close to the 10 side of the scale) The total cost is your time, money and energy to get the job done whether you do it yourself or hire a professional.
Key Takeaway
If you think crypto tax calculations are a nightmare you ain’t seen nothin’ yet. The cost of going through the reconciliation ringer is going to double, triple or quadruple the time, money and energy to file your crypto taxes under the new proposed rules.
Good luck. You’ll need it. Remember there’s always a way so stay tuned as this plays out in the years to come.
