Submitted by Anthony Brunson, P.A.
Digital assets have become an increasingly popular method of payment and an asset for investment or trading. Because many transactions involving digital assets fall outside the scope of information reporting rules, on August 25, 2023, the government issued proposed regulations for them. The new rules are intended to make it easier for taxpayers to track and report their gain or loss from dispositions of digital assets, and to enable the IRS to focus its audit efforts on taxpayers more likely to have underreported income from digital asset transactions.
More specifically, the new proposed regulations concern how to determine (1) gains or losses on sales of digital assets, (2) the basis of a digital asset, and (3) broker-reporting requirements. The proposed regulations also include coordination rules to avoid duplicate reporting.
Under the proposed regulations, for digital assets acquired after January 1, 2023, brokers will be required to report gross proceeds for digital asset sales and exchanges that occur on or after January 1, 2025, and provide gain or loss and basis information for sales and exchanges that occur on or after January 1, 2026.
Taxpayers who engage in transactions using digital assets will begin receiving information returns after January 1, 2026. The information will be reported on new form 1099-DA.
The proposed act
The Infrastruc-ture Investments and Jobs Act of 2021 expanded the broker reporting provisions under IRC Section 6045 to cover digital assets. A digital asset is defined as “any digital repre-sentation of value that is recorded on a cryptographically secured distributed ledger … without regard to whether each individual transaction involving that digital asset is actually recorded on that ledger.” That is, a digital asset, broadly defined, is any digital representation of value which is recorded on blockchain.
The use of distributed ledger technology for commercial purposes, such as tracking inventory, and other virtual assets are not included in the definition.
Those who fall under the new definitions of broker for digital assets will be required to report to the IRS and their customers (1) the customer’s adjusted basis in the digital asset, (2) any capital gains or losses on sales of digital assets, and (3) whether any such gains or losses were short- or long-term.
Further definitions
As outlined by the U.S. Department of the Treasury, further changes would include:
Gain or loss. The proposed regulations would determine the gain or loss on the sale of digital assets. The gain or loss would be generally equal to the sum of any cash received for the digital asset, plus the fair market value of any property received for the digital asset or the value of any debt note issued, plus the FMV of any services received in exchange for the digital asset, less the amount of transaction costs allocated to the disposition of the digital asset.
Transaction costs for digital assets would be defined as any cash or property paid to dispose of or acquire a digital asset, but typically allocated to the digital asset’s disposition. However, if a digital asset were used to acquire another digital asset distinctly different in kind or extent, the transaction costs would be split equally between the sold and acquired assets.
Fair market value. The FMV of a digital asset would be determined as of the date and time of the exchange or transaction.
Determination of basis. The basis of a purchased digital asset would be equal to the FMV plus the total allocable transaction costs. When exchanging digital assets of significantly different kinds, the basis would equal the cost of the acquired digital asset plus one-half of the allocable transaction costs.
Definition of broker. The definition of “broker” would be expanded to include digital asset trading platforms, digital asset payment processors, certain digital asset-hosted wallet providers, and persons who regularly offer to redeem digital assets that they created. The definition would include people who sell or license software to unhosted wallet users if they facilitate (or offer services to facilitate) the purchase or sale of digital assets. In other words, a broker would be defined as any agent, principal or middleman that “effectuates sales of digital assets.”
The definition of broker would exclude merchants who accept digital assets for goods or services; people who only validate transactions through proof-of-work, proof-of-stake or other consensus mechanism; NFT creators; and people who only sell hardware or licensing software without additional services.
Broker reporting requirements. The reporting requirements for brokers would be broadened to cover the facilitation of digital asset sales, including dispositions of digital assets for cash, stored-value cards, broker services and other digital assets.
Real estate transactions involving digital assets would fall under the definition of “real estate reporting persons” and would be subject to those reporting requirements.
Duplicate reporting. The regulations would limit overlap in reporting, so that brokers in transactions where an asset could be classified as both a digital asset and another type of property, such as a commodity or security, would not be subject to duplicate reporting.
Backup withholding. The proposed regulations would clarify when backup withholding applies to digital asset transactions and when certain exceptions under the rule would apply to brokers.
The taxation of digital assets is an evolving area, which makes it extremely complicated. While the new rules are currently in proposed form, taxpayers should consult a tax professional to be sure they are considering all of the potential impact of these rules on their current and future transactions.
