Prior to 2009, digital assets were anything that was created and stored digitally and provided value, like data or an image. With the introduction of Bitcoin, the landscape drastically changed and digital assets became more common as they are increasingly being used as a method of payment, as well as an investment asset. Because of this, the government needed to update their reporting rules, as the current reporting methods were not fully encompassing; taxpayers were often left to keep track of their own gains and losses with little direction, leading to underreporting. On August 25, 2023, the IRS proposed new regulations that are intended to make it easier for taxpayers to report their gains and losses for the sale of digital assets. These regulations on digital assets fall under four main categories: how to calculate the gain or loss on sales, how to calculate the basis, broker reporting requirements, and coordination rules. These highly anticipated regulations are the most substantive and extensive guidance regarding digital assets to date.

A digital asset is described 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 that digital asset is actually recorded on that ledger, and that is not cash (Prop. Reg. Sec. 1.6045-1(a)(19)(i)).” Cryptocurrency, NFTs and stablecoins are included in this definition of digital assets, while video game tokens and other in-game currencies are not.

Gains or Losses on Sales of Digital Assets

According to Prop. Reg. Sec. 1.1001-7, the amount of gain or loss realized on the sale of a digital asset is equal to the total of: any cash received, (plus) the fair market value of any property received or the value of any debt note, (plus) the fair market value of any services received, and (less) the amount of transaction costs related to the sale.

The fair market value of a digital asset is decided “as of the date and time of the exchange or transaction (Prop. Reg. Sec. 1.1001-7(b)(3)).” When there are situations where the fair market value is unclear, the fair market value would be decided based on other transactions, used as a reference, of digital assets transferred at the same date and time of the exchange. This determination of fair market value is different from the fair market value of stocks and bonds, which is calculated by taking the mean between the lowest and highest selling prices on the day of valuation.

Digital transaction costs include “transaction fees, transfer taxes, and commissions (Prop. Reg. Sec. 1.1001-7(B)(2)(i)).” They are considered “any amount paid in cash or property to effect the disposition or acquisition of a digital asset.” Usually, the digital asset transaction costs are allocated to the disposition. If a digital asset is sold in order to acquire another materially different digital asset, half of the transaction costs paid by the taxpayer are allocated to the sale and the other half is allocated to the basis of the new digital asset.

Basis of Digital Assets

Under Prop. Reg. Sec. 1.1012-1(h), which would amend Treas. Reg. Sec. 1.1012-1, the basis of a digital asset would be “equal to the cost thereof at the date and time of the purchase or exchange, plus any allocable digital asset transaction costs,” as described above. If a digital asset is sold in order to acquire another materially different digital asset, the basis is the cost of the new digital asset plus half of the transaction costs.

Broker Reporting Requirements

The regulations require those doing business as a broker to provide a return showing each customer reporting information such as the gross proceeds and adjusted basis. Brokers would be defined as “any person who acts as an agent, principal, or middleman to effectuate sales of digital assets,” which would include “digital asset trading platforms, payment processors, hosted wallet providers, and those that offer to redeem digitals assets that they created or issued (Prop. Reg. Sec. 1.6045-1).” Merchants that sell goods and services in return for digital assets would not be considered a broker. Sales would include dispositions of digital assets for cash, stored value cards, broker services, and other digital assets. If digital assets are used to purchase property, these type of real estate transactions would fall under these requirements and those involved with the transaction (attorneys, mortgage lenders) would need to report the required information. Sales would not include when a customer receives digital assets without disposing of something or when a customer received digital assets in return for services.

Coordination Rules

These rules would be put into place to avoid duplicate reporting, where an asset could be classified as both a digital asset and another type of property, for example a commodity or security. Proposed regulations would also address reporting requirements for third party network transactions. Any payment made using digital assets for goods or services, which is also considered a sale of a digital asset, would be reported under Tres. Reg. Sec. 1.6045-1. If the goods are digital assets and a sale has taken place, this would also be reported under Tres. Reg. Sec. 1.6045-1.

Backup Withholding

Under the proposed regulations, if a valid taxpayer identification number is not provided, brokers may be required to deduct and withhold tax at the statutory backup rate of 24%. Exceptions would include when the broker is a controlled foreign corporation or a non-U.S. broker. Should the broker have knowledge that the payee is from the United States, the exception would not apply.

Important Dates

The proposals concerning the amount realized on the sale of digital assets and determining basis would be applicable on or after January 1 of the calendar year immediately following the publication of final regulations. So, taxpayers should rely on these proposed regulations for the upcoming taxable year.

Brokers would be required to report gross proceeds for digital asset sales and exchanges that happen on or after January 1, 2025. Gain, loss, and basis information would be provided for sales and exchanges that happen on or after January 1, 2026, for any assets acquired after January 1, 2023.

Taxpayers using digital assets should be aware of these proposed regulations and understand the required reporting information needed in the future. The IRS plans to continue to expand and enforce their digital asset regulations, instead of relying on the truthfulness of taxpayers. The accuracy of digital asset reporting will become more critical, as the IRS is cracking down on these taxable transactions; after January 1, 2026, this information will be reported on Form 1099-DA. The IRS will also be welcoming comments and feedback on these proposed regulations and a public hearing will be held on November 7, 2023. Please contact your tax professional at Dermody, Burke & Brown so we can help you navigate the complexities of these new filing requirements.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.