IRS releases broad guidance on digital assets

The IRS released much-anticipated proposed regulations on Aug. 25 that delay broker reporting but provide extensive guidance on transactions involving digital assets. The proposed regulations are the most substantive guidance to date related to digital assets, and provide rules for information reporting, the computation of gain or loss and back-up withholding.

The new rules are not immediately effective, but taxpayers may generally rely on the proposed rules for tax years ending after they are published in the Federal Register. Broker reporting on gross proceeds is delayed under the rules until 2025, while reporting on basis is delayed until 2026. The deadline for written or electronic comments on the proposed regulations is Oct. 30, 2023.

Background

The Infrastructure Investments and Jobs Act of 2021 (the IIJA) expanded the broker reporting provisions under Section 6045 to cover digital assets. Specifically, the IIJA clarified that: (i) the definition of “broker” included any person who, for consideration, is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person; and (ii) the definition of “covered security” under Section 6045(g) included any digital asset. The IIJA also defined “digital asset” broadly to mean any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by Treasury.

Digital assets have become an increasingly popular method of payment and asset for investment or trading. The government expressed a need for the proposed regulations because many transactions involving digital assets were outside the scope of information reporting rules. The government stated that new rules are intended to make it easier for taxpayers to properly track and report their gain or loss from dispositions of digital assets, and enable the IRS to focus its audit efforts on taxpayers more likely to have underreported income from digital asset transactions.

Definition of digital asset

The proposed regulations provide a broad definition for “digital asset” as any digital representation of value that is recorded on a cryptographically secured distributed ledger (or any similar technology), without regard to whether each individual transaction involving a digital asset is actually recorded on that ledger. The definition includes digital assets that may be recorded using technology that uses cryptography to secure transactions, and is intended to include non-fungible tokens (NFTs) and stablecoins, as well as other digital assets. 

The proposed regulations clarify that the definition of digital asset does not include cash. In addition, it is intended that the proposed regulations do not apply to virtual assets in a closed system (e.g., video game tokens that can be purchased with U.S. currency or other fiat currency and can be used only in such a video game).

The proposed regulations specify that nothing in the proposed regulations may be construed to mean that a digital asset is, or is not, properly classified as a security, commodity, option, securities futures contract, regulated futures contract, or forward contract for any other purpose of the Code.

Computation of gain or loss of digital assets

A new proposed regulation under Section 1001 provides rules to determine gain or loss upon the sale, exchange, or other disposition of digital assets. 

Gain is generally calculated as the amount realized over the basis in the digital asset. Generally, the amount realized is the excess of cash received, plus the fair market value of any property (including digital assets) or services received, subtracted by any digital asset transaction costs.

The fair market value of a digital asset is determined as of the date and time of the exchange or disposition of such digital asset. If the fair market value of property (including digital assets) or services received cannot be determined with reasonable accuracy, the fair market value of such property or services must be determined by reference to the fair market value of the digital assets transferred. If a debt instrument subject to Treas. Reg. Sec. 1.1001-1(g) is issued as consideration for digital assets, the amount attributable to the debt instrument is the issue price.

The proposed regulations provide new rules under Section 1012 to determine the basis of digital assets. Generally, the basis of digital assets received in a purchase or exchange is equal to the cost at the date and time of the purchase or exchange, plus any digital asset transaction costs. Rules under Sections 61 and 83 are referenced for digital assets received in connection with the performance of services and rules under Treas. Reg. Sec. 1.1012-2 are referenced for digital assets received in a transfer that is part a sale and part a gift.

If a debt instrument is issued in exchange for digital assets, the cost of the digital assets is the issue price as determined under Treas. Reg. Sec. 1.1012-1(g).

The proposed regulations also provide rules for specifically identifying digital assets for determining basis and the holding period when a taxpayer sells, disposes of or transfers less than all units of the same digital asset. If specific identification is not made, units are disposed of in order of time from the earliest acquired (i.e. first-in, first-out). The specific identification of digital assets sold, disposed of, or transferred is made if the taxpayer identifies on its books and records particular units to be sold, disposed of or transferred no later than the date and time of the sale, disposition or transfer. A specific identification can be made only if adequate records are maintained for all units of a specific digital asset held in a single wallet or account to establish that a disposed unit is removed from the wallet or account for subsequent transactions.

Where multiple units of the same digital asset are left in the custody of a broker, adequate identification occurs if, no later than the date and time of the sale, the taxpayer specifies to the broker the particular units of the digital assets to be sold by reference to any identifier such as purchase date and time, or purchase price.

The proposed regulations state that a method for specifically identifying units of a digital asset is not a method of accounting to which Sections 446 and 481 apply.

Digital Asset Transaction Costs

“Digital Asset Transaction Costs” are defined as the amount paid in cash or property to affect the disposition or acquisition of a digital asset. Digital Asset Transaction Costs include transaction fees, transfer taxes and commissions. Digital Asset Transaction Costs are generally allocable to the disposition of the digital assets. However, in the case of an exchange of digital assets, one half of the total Digital Asset Transaction Costs paid by the taxpayer to effect the exchange are allocable to the disposition of the transferred digital assets, and the other half of such costs are allocable to the acquisition of the digital assets received.

Reporting requirements

Section 6045 generally requires every person doing business as a broker to make a return showing each customer with information such as gross proceeds and other information required by Treasury. Section 6045(g), which applies to digital assets under the IIJA, requires the information reported by a broker related to covered securities and digital assets to include the customer’s adjusted basis.

The proposed regulations clarify that the definition of “broker” under Section 6045 includes digital asset trading platforms, digital asset payment processors, certain digital asset hosted wallet providers, and persons who regularly offer to redeem digital assets that were created by that person.

Specifically, the proposed regulations include as a broker a person that provides facilitative services that effectuate sales of digital assets by customers provided the nature of the arrangement is such that the person ordinarily would know, or would be in a position to know, the identity of the party that makes the sale and the nature of the transaction potentially giving rise to the gross proceeds.

The definition includes persons who sell or license software to unhosted wallet users if they facilitate or offer services to facilitate the purchase or sale of digital assets. However, the term “broker” does not include merchants that sell goods or services in return for digital assets, persons who are solely engaged in the business of validating transactions through proof-of-work, proof-of-stake or another consensus mechanism, and persons who are solely engaged in selling hardware or licensing software without such persons providing other functions or services. The IRS expects that the definition in the proposed regulations will require decentralized exchanges to collect customer information and report sales information about their customers.

A “sale” is defined to include: (i) any disposition of a digital asset in exchange for cash or stored-value cards; (ii) any disposition of a digital asset in exchange for a different digital asset; and (iii) the delivery of a digital asset pursuant to the settlement of a forward contract, option, regulated futures contract, any similar instrument or any other executory contract. 

The term “sale” also includes transactions involving digital assets and a broker that is a real estate reporting person or is in the business of effecting sales of property. The definition of sale is expanded further to include certain transactions related to digital assets entered into by a “digital asset payment processor” as defined in the proposed regulations.

The IRS stated that a sale does not include: a transaction in which a customer receives new digital assets without disposing of something else in exchange, the receipt by a customer of digital assets from an airdrop, or a transaction in which a broker’s customer receives digital assets in return for the performance of services.

A U.S. digital asset broker and a CFC digital asset broker not conducting a money services business (MSB) generally report on all sales other than sales effected for an exempt recipient or an exempt foreign person.  A non-U.S. digital asset broker, as defined in the regulations, not conducting an MSB is required to report sales effected at an office inside the U.S., which may include sales that the broker collects documentation or information that indicates the customer has connections to the U.S. or may be a U.S. person. Special rules and considerations apply to CFC digital asset brokers and non-U.S. digital asset brokers that conduct activities as MSBs.

The government will release a new Form 1099-DA for reporting of sales of digital assets. For each sale of a digital asset on or after Jan. 1, 2025, the broker will need to report the following information:

• The name, address and taxpayer identification number of the customer
  
• The name and number of units of the digital asset sold
• The sale date and time
• The gross proceeds amount (after reduction for the allocable digital asset transaction costs)
• The transaction ID in connection with the sale, if any
• The digital asset address (or digital asset addresses) from which the digital asset was transferred in connection with the sale, if any
• Whether the sale was for cash stored-value cards, or in exchange for services or other property.

For each sale of a digital asset on or after Jan. 1, 2026, the broker must also report the adjusted basis, the date and time of purchase, and whether any gain or loss is long-term or short-term (within the meaning of Section 1222).

For each sale of a digital asset that was held by the broker in a hosted wallet on behalf of a customer, and was previously transferred into an account at the broker (a transferred-in digital asset), the broker must also report the following:

• The date and time of such transfer-in
  
• The transaction ID of such transfer-in, if any
• The digital asset address (or digital asset addresses if multiple) from which the digital asset was transferred, if any
• The number of units transferred in by the customer.

If a sale of a digital asset gives rise to digital asset transaction costs that are paid using digital assets, the sale of the digital asset to pay for the digital asset transaction costs must also be reported as a sale.

The IRS in the guidance delayed the effective date of the reporting requirements for digital assets:

• Brokers are not required to report the gross proceeds from the sale of a digital asset if the sale is effected prior to Jan. 1, 2025.
  
• Brokers are not required to report the adjusted basis of sold digital assets in a sale on or after Jan. 1, 2026.

The government noted that some digital asset brokers currently treat payments of cash for digital assts, or exchanges of digital assets, as reportable payments under Section 6050W. The proposed regulations do not take a position on whether these payments are reportable under Section 6050W, but provide rules to avoid duplicative reporting.  

Back-up withholding

Section 3406 requires certain payors of reportable payments to deduct and withhold tax at the statutory withholding rate (24%) if the payee does not provide a correct Taxpayer Identification Number.

The proposed regulations provide back-up withholding rules for brokers reporting on foreign currency contracts and regulated futures contracts subject to Section 1256 and security sales and short sales.  Comments are requested on whether changes should be made to address digital assets that may be securities or short sales of digital assets.

The proposed regulations also clarify that a sale of digital assets in return for real estate effected by brokers should be subject to back-up withholding notwithstanding an existing rule that does not require back-up from real estate reporting persons.

The proposed regulations also provide that a payor is not required to back-up withhold on a sale of digital assets effected at an office outside the United States by a CFC digital asset broker that is not conducting activities as a money services business with respect to that sale and to a sale of digital assets effected by a non-U.S. digital asset broker that is not conducting activities as a MSB with respect to that sale. However, the exceptions do not apply when a payor or broker has actual knowledge that the payee is a U.S. person.

Applicability dates

The regulations regarding the computation of gain or loss under Sections 1001 and 1012 are proposed to apply to taxable years of sales and acquisitions of digital assets on or after Jan. 1 of the calendar year immediately following publication of final regulations. Taxpayers may rely on the proposed regulations for taxable years ending after the publication of the proposed regulations in the Federal Register.

The reporting of gross proceeds from the sale of digital assets is required by a broker for sales on or after Jan. 1, 2025, and the reporting of adjusted basis and the character of gain or loss is required by a broker for sales on or after Jan. 1, 2026.