Proposed Regulations for Determining Proceeds, Basis, and Reporting Requirements for Digital Assets
The IRS released proposed regulations on August 25, 2023, addressing how to determine gains or losses on sales of digital assets, how to determine the basis of a digital asset, new broker reporting requirements for digital assets, and coordination rules to avoid duplicative reporting. The broker reporting requirements for digital assets were added to the Internal Revenue Code (IRC) by the Infrastructure Investment and Jobs Act (“Infrastructure Act”). Under the proposed regulations, brokers would 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, for digital assets acquired after January 1, 2023. The IRS is actively seeking comments on the proposed regulations and has set aside two days for public hearings and comments.
Definition of Digital Assets
Those who fall under the new definitions of “broker” for digital assets would be required to report to the IRS and their customers: (i) the customer’s adjusted basis in the digital asset, (ii) any capital gains or losses on sales of digital assets, and (iii) whether any such gains or losses were short- or long-term. The proposed regulations generally incorporate the definition of a digital asset from the Infrastructure Act, with some modifications. Prop. Reg. Sec. 1.6045-1(a)(19)(i) defines a digital asset as “any digital representation 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.” The preamble specifically states that this definition of digital assets includes NFTs and stablecoins. The use of distributed ledger technology for commercial purposes, such as tracking inventory, and other virtual assets, such as video game tokens or in-game currency, are not included in this definition of digital assets.
Determining Amount Realized on Disposition of a Digital Asset
The proposed regulations would add Prop. Reg. Sec. 1.1001-7 to address the determination of gain or loss realized on a sale of a digital asset. Under Prop. Reg. Sec. 1.1001-7, the amount realized is generally equal to:
- the sum of any cash received for the digital asset; plus
- the fair market value (FMV) 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.
Digital asset transaction costs would be defined as any cash or property paid to dispose of or acquire a digital asset. Generally, the total digital asset transaction costs are allocated to the disposition of the digital asset. However, if a digital asset is used to acquire another digital asset “differing materially in kind or in extent,” the allocable amount of transaction costs for determining the amount realized is equal to one-half the transaction costs paid by the taxpayer. The other half is allocable to the basis determination of the digital asset received. Prop. Reg. Sec. 1.1001-7(b)(1)(ii) clarifies that when digital assets are used to pay digital asset transaction costs, this use would also be considered disposition of the digital asset for services.
Fair Market Value
Prop. Reg. Sec. 1.1001-7 would also address determining the FMV of a digital asset. Under Prop. Reg. Sec. 1.1001-7(b)(3), the FMV of a digital asset would be “determined as of the date and time of the exchange or transaction.” In situations where the FMV of property or services received in exchange for digital assets is difficult to ascertain with “reasonable accuracy,” Prop. Reg. Sec. 1.1001-7(b)(4) states that the FMV would be determined “by reference to the fair market value of the digital assets transferred as of the date and time of the exchange.” For a trade on a centralized exchange where the USD rate is readily apparent, this may be easier to identify. However, valuation may be more difficult in other situations. This is in contrast to the FMV of stocks and bonds, which is determined by taking the mean between the lowest and highest quoted selling prices on the valuation date.
Determination of Basis
The proposed regulations would also amend Treas. Reg. Sec. 1.1012-1 to address the calculation of the tax basis of digital assets. Under Prop. Reg. Sec. 1.1012-1(h), the basis of a purchased digital asset would be equal to the cost of the asset at the date and time of the purchase or exchange, plus total costs allocated to the transaction. In situations where the taxpayer exchanges a digital asset for another digital asset “differing materially in kind or in extent,” the basis would equal the cost of the acquired digital assets plus one-half of the allocable transaction costs.
Proposed Changes to Broker Reporting Requirements
Under the proposed changes to Treas. Reg. Sec. 1.6045-1, reporting requirements would be extended to brokers who facilitate sales of digital assets. “Sales” includes dispositions of digital assets for cash, stored-value cards, broker services, and other digital assets. The proposed regulations would define a broker as any person who acts as an agent, principal, or middleman to “effectuate sales of digital assets.” This would include digital asset trading platforms, payment processors, hosted wallet providers, and those who offer to redeem digital assets that they created or issued. (Prop. Reg. Sec. 1.6045-1(b)(20) clarifies that where an NFT creator uses a digital asset broker, the NFT creator would not be considered a broker.) For real estate transactions where digital assets are used to purchase property, the proposed regulations also stipulate that “real estate reporting persons” would fall under the reporting requirements. Under existing IRC Sec. 6045(e)(2), a “real estate reporting person” means certain persons involved in the real estate transaction, including a closing attorney or titling company, mortgage lenders, and both the seller’s and buyer’s brokers.
The definition of brokers would also be extended to include those providing facilitative services who “ordinarily would know or be in a position to know” the identity of the person making the sale and the gross proceeds of the sale under Prop. Reg. Sec. 1.6045-1(a)(21)(i). The preamble states that this definition would be expanded so the requirements would apply to decentralized exchanges that typically do not collect customer information, and to discourage platforms from switching to decentralized formats to avoid the reporting requirements.
Coordination to Avoid Duplicate Reporting
The proposed regulations would add Prop. Reg. Sec. 1.6045-1(c)(8), which would limit the possibility of duplicate reporting obligations for 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. Proposed changes to Treas. Reg. Sec. 1.6050W-1 would also address the potential for duplicate reporting requirements for payment cards and third-party network transactions. If a payment is made using digital assets for goods and services and the exchange is considered a sale of digital assets under Prop. Reg. Sec. 1.6045-1(a)(9), the exchange would be reported under Treas. Reg. Sec. 1.6045-1 instead of Treas. Reg. Sec. 1.6050W. If the goods or services provided by a payee are digital assets and the transaction is considered a sale of digital assets, the exchange would also be reported under Treas. Reg. Sec. 1.6045-1.
The proposed regulations would clarify when backup withholding applies to transactions involving digital assets, and when certain exceptions under IRC Sec. 6045(c) would apply to brokers. If the payee fails to provide a valid taxpayer identification number, brokers may be required to withhold at the statutory backup withholding rate (currently 24%). The regulations would provide exceptions from backup withholding when the broker is a controlled foreign corporation or a non-U.S. broker “not conducting activities as a money services business.” However, if the broker has “actual knowledge” that the payee is a United States person, the exception would not apply. The proposed regulations would also address backup withholding requirements for real estate reporting persons above.
Effective Dates of Regulations
The proposed regulations have multiple effective dates for different sections.
Amount Realized and Adjusted Basis
The Prop. Reg. Secs. 1.1001-7 and 1.1012-1(h)-(j) would be applicable for taxable years beginning on or after January 1 of the calendar year following the publication of the finalized rules. Taxpayers may rely on these proposed regulations for dispositions of digital assets in taxable years ending on or after August 29, 2023, provided they apply them in a consistent manner.
Proposed Changes to Broker Reporting Requirements
Under the proposed regulations, brokers would be required to report gross proceeds from sales or exchanges of digital assets occurring on or after January 1, 2025. Brokers would be required to report adjusted basis information for sales or exchanges occurring on or after January 1, 2026, with respect to any digital assets acquired on or after January 1, 2023. Accordingly, digital assets purchased prior to January 1, 2023, would not be covered to the proposed changes to the basis rules.
IRS Enforcement Efforts with Digital Assets
The IRS has indicated in other communications and news releases that it intends to focus on guidance related to digital assets as part of its larger enforcement efforts. The IRS has generally relied on voluntary reporting of transactions with digital assets, though the agency has been increasingly aggressive in its attempts to enforce reporting. A primary purpose of information returns is to report possible taxable transactions to the IRS to increase compliance. The IRS believes these broker reporting requirements will make it easier to determine if taxpayers are accurately reporting their transactions with digital assets.
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. As many forms are now provided electronically, taxpayers may not receive a physical copy of their form 1099-DA. Taxpayers who believe they will be impacted by the increased attention on digital asset transactions should engage a trusted tax advisor to help them navigate the changes ahead.
For more information explore Blockchain & Digital Assets.
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