Breaking Down The Cryptocurrency Tax Proposals In Congress

Jordan Bass of the firm Taxing Cryptocurrency discusses the proposed cryptocurrency tax changes that Congress is considering and how they could affect taxpayers and the digital asset industry.

This transcript has been edited for length and clarity.

Marie Sapirie: Thank you, Jordan, for joining me today to discuss the rapidly changing tax rules and in particular, the tax information reporting rules for digital assets.

Jordan Bass: Thank you for having me. Looking forward to having this discussion.

Marie Sapirie: There are proposed legislative changes to tax information reporting for digital assets that are included as an offset in the infrastructure bill that Congress is currently working on. Before we get to those proposed changes, would you give us an overview of how the tax rules for cryptocurrencies and other digital assets have developed so far?

Jordan Bass: Of course. The taxation and treatment of digital assets and cryptocurrencies has kind of been stagnant for a long period of time, ever since we had the initial guidance released by the IRS in 2014. Even though people hadn’t necessarily reviewed that guidance, there’s been very, very straightforward treatment of most transactions since then.

A trade for crypto to crypto would constitute a taxable event. A trade for crypto to cash would constitute a taxable event. If you’re just purchasing the asset with U.S. dollars, you’re going to set up your basis in that asset, but that’s not going to trigger any tax. That was basically the initial taxation treatment of these transactions.

Over time, the market kind of became more sophisticated, developed. There’s been different structures of transactions that have been created with borrowing and lending on chain, providing liquidity on chain in some of these decentralized exchanges.

Because the structures of the transactions have changed, the way that it’s taxed has also changed. There were initial coin offerings, or ICOs. There were airdrops that people would receive. There were forks from different chains. All of those events that changed how the initial tax treatment would be, where it was just a simple swap going from one coin to another, or going from U.S. dollars to a cryptocurrency or vice versa, created some complexity that caused confusion for a lot of taxpayers. There wasn’t really any guidance on those particular transactions until recently.

There’s so many different ways that a taxable event could arise in the digital assets space. Not just what we’ve mentioned already, but even mining and staking your tokens. They’re income generation events that haven’t necessarily had that sort of guidance released by the IRS. But we can take existing tax principles and apply it to those transaction structures.

That’s what we’ve been doing mostly for the last six, seven, eight years that we’ve seen tax reporting done with crypto and digital assets. The main thing that has advanced the ability to report these transactions in a more clean way is there’s been a lot of infrastructure built out from a software perspective and also an analytic perspective. You can actually see your transactions allocate cost basis and then also determine what your proceeds were if there was a taxable event, if it was a trade, or see what the fair market value of the tokens were that you received on a day when you had an income-generating event.

But early on, that wasn’t necessarily the case. That may have caused a level of confusion and created additional complexity that maybe didn’t need to necessarily be there with early crypto adopters. But all of that has led us to the point where we are today, where there’s a regulatory framework and governmental bodies that are trying to regulate the space in an effort ultimately to, in their mind, protect investors, but also generate tax revenue from a space and a market that there may be an underpayment, so they believe, of tax liabilities from a lot of U.S. individuals and entities.

Marie Sapirie: Turning to the current debate in Congress, in the August draft of the infrastructure bill, changes were proposed to the definitions of the terms broker and digital asset. These changes have attracted some criticism, especially around the process through which the proposed changes are being introduced. The IRS had guidance under section 6045 on its priority guidance plan in 2019. But the legislative process is relatively new.

First, let’s look at the definition of broker because brokers are who’s required to submit information returns to the IRS and to customers. Would you take us through the proposed definition of broker and the implications of this change?

Jordan Bass: There were multiple amendments that were offered in the Senate to address this issue that we’re going to be discussing. But ultimately the current definition is very, very broad for people in the crypto space. I’m sure on the other side, in the regulatory space, maybe there needs to be additional guidance to further define what this means.

But, the definition is any person for consideration that’s responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person. In a way, this makes sense if the target is centralized cryptocurrency exchanges, which honestly in many ways function like the traditional broker-dealers or traditional centralized exchange sort of platforms in traditional security markets. The Coinbases, the Krakens, the Geminis, the FTX U.S., the Binance U.S. They have the ability to take on a lot of this information and report some of the transactions directly to, let’s say, the IRS. They may have the infrastructure to do so.

But the problem that a lot of people in the industry expressed concern with, and really we’re looking for that revised definition is that definition of any person. It’s very broad and could be interpreted to include people that are mining Bitcoin or other currencies. People that are maintaining a DeFi platform, a decentralized finance platform. Even though they don’t have that information readily available to report some of the transactions, they would still be included in that.

For example, the miners in this space validate transactions. In theory, they could be responsible for regularly providing any service that effectuate transfers of the digital assets on behalf of another person. But they don’t have that information on who’s the underlying parties in the transactions.

Same thing goes with these DeFi platforms and protocols. They execute transfers. They execute transactions of crypto or help facilitate that based on something that’s established in the code. But they don’t really need any human intervention.

This could also include many, many other noncustodial sort of actors in the crypto space. I think it’s more of an issue when you’re talking about the DeFi protocols. They have users, but they don’t have customers. They just allow people to utilize this software. They don’t collect information like an entity or an exchange would when they Know Your Customer (KYC) their users or their customers in the centralized exchange sort of example.

This could also include proof of stake validators. This could include a lot of market participants. I think the regulation is more so garnered toward the DeFi space and the liquidity providers. It really just depends on how that additional guidance comes to play and comes out. But as of now, it’s a very, very broad definition of what is deemed to be a broker for the section 6045.

Marie Sapirie: In addition to adding the broker definition, the proposal would also add a definition of the term digital asset. The proposed definition includes, “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” What are some of the possible effects of that new definition?

Jordan Bass: I think that this is another broad definition. Obviously this would include digital assets. People are familiar with Bitcoin or Ethereum or other cryptographically secured value that’s cryptographically secured on a distributed ledger or any similar technology.

But what this could also do is extend beyond cryptocurrency. People are really focused on cryptocurrencies. Things that we see in the market that kind of go up and down and are very, very volatile, but have had amazing returns for a lot of early-on investors.

This could technically apply to other digital goods. This could apply to another space that we’ve seen kind of a boom in recently, the non-fungible token (NFT) space. Because technically that asset could be a digital representation of value, which is what’s in the definition. It’s definitely recorded on chain or in some other sort of similar ledger in what they described in the amendment.

I think it has the ability to include more assets than just what we’re talking about when we think of cryptocurrency. There could be a whole bunch of assets that become tokenized, that are stored on chain, that have some sort of digital representation of value that aren’t necessarily what we think of today or what we see today. We have potential in the future to have security tokens. We have the potential for some real property assets to be tokenized and represented with value on chain.

I think the definition is pretty broad, but as of now, I don’t personally believe that there are any issues per se with that definition. I think the big issue in the space mostly is related to what a broker is.

But that digital asset definition does bring into play something that could extend beyond cryptocurrencies, which again is basically the main point and issue with what is trying to be regulated supposedly with these amendments.

Marie Sapirie: The definition of digital asset clearly anticipates regulatory guidance with their similar technology as specified by the Secretary. It seems likely that there will be other types of guidance from Treasury and the IRS on other aspects of the proposed statutory changes. What would be helpful for Treasury and the IRS to consider while they’re drafting that guidance?

Jordan Bass: I think that the key in all of these issues would be really focused on those centralized exchange actors that are processing billions of dollars’ worth of volume on a day-to-day basis in trades. They’re the ones where you have the fiat on-ramp and off-ramp. They’re the places where you can track, in my opinion, what’s going on in the actual trading activity of an individual or an entity that is engaging in this market.

The key for me is I do really believe this is about decentralized finance. Some people think that there are activities occurring on chain without banks, and it can’t be tracked. That’s not true. It’s all occurring on chain, so you can really, really see what’s going on.

But the way to regulate this space, in my opinion, would be to focus on the centralized authorities that are definitely willing to comply with these regulations, because some of them, like Coinbase, are public companies. Maybe some of them want to go public in the future and they don’t want to be in any hot water with regulators.

If you focus on that space and the money going in and going out and have those individuals and those companies be the ones that are reporting this information and being forced to report this information, you create this innovation-free zone for what’s going on in the DeFi space. You allow for these companies to want to stay in the U.S. and not feel the need to kind of move offshore.

We don’t want to stifle innovation in this space because it does have the ability to generate from an individual and an investor standpoint a lot of wealth and a lot of asset accumulation for people in crypto. But those taxpayers are eventually going to have to pay tax when they either sell off a large portion of their assets if they’re sitting in unrealized gain positions, or if they’re utilizing these DeFi protocols and platforms to earn certain yields and earn income for the year. That’s going to create income generation events for them, taxed at ordinary income rates, not even capital income rates. The IRS will receive more tax revenue from that.

The thing is, are those people going to report their income the right way and report and pay their tax liability in the way that somebody who received a 1099 or W-2 from their employer would?

These are things that are tracked very easily by the IRS. They can clearly see and match somebody reporting their income on their return and what they’ve actually received in terms of documentation that is required to go to the state and federal governments for tax purposes.

But if the focus was on the centralized exchanges, and there was an ability to track assets moving to and from centralized exchanges to unhosted wallets that aren’t really custodied by somebody that has the ability to KYC their users, then in theory, all of that tax money would come into the IRS.

There are many firms that do this on-chain analysis that can see wallet address movement of crypto from one wallet to another. If the centralized exchange helped the IRS in that case, because they’re being regulated as such, and they want to make sure that they’re complying with all the laws, then I think that’s really where the focus should be. Not on indirectly killing a huge industry and a huge portion and sector of the crypto space like DeFi with regulation that maybe is unnecessary in a lot of people’s opinion.

It is also completely overbroad with lack of guidance being issued, which has kind of been a theme for the IRS or for any sort of regulatory body when it comes to crypto. Maybe people want this further guidance, but they haven’t really received it over time. If that’s going to continue to be the case when we’re talking about what a broker is, or what is included in a digital asset, then it’s going to continue to create confusion.

We don’t want to have all these huge companies that are bringing billions and billions of dollars of value to the crypto space move and not want to set up their entities in the U.S. and completely stifle this industry in the U.S.

I think the most important thing is really focused on the centralized actors. You can worry about the people that are validators or mining or the DeFi protocols, but in a more of an indirect regulation, an indirect cleaning up of that space by directly regulating the places where you can put money into the market and take money out of the market. Currently, there’s no bridge to go from a DeFi protocol like Compound or Aave to your Wells Fargo account. But there definitely is a way to go from your Coinbase account to your Wells account.

Those are the transactions that are currently can be tracked, and those are the ones that should be. Those are the actors — the centralized exchanges — in my opinion, that should be regulated.

Marie Sapirie: The broker definition has been a major focus recently, but there’s another proposed change to section 6050I that would treat any digital asset, as defined in the proposed change to section 6045 that we just discussed, as cash for purposes of section 6050I, which also imposes reporting requirements.

How would those requirements work? What are some of the potential consequences of this proposal that should be considered?

Jordan Bass: That’s another big proposal because in theory, we have transactions that need to be reported every day when there’s a certain dollar threshold that’s met in cash. But if digital assets are going to be treated as cash for the section, then in theory, any person that is engaged in a trade or business that receives or sends out $10,000 worth of digital assets will have to report this information directly to the IRS.

Again, the digital asset definition is defined very broadly. This could include digital assets in addition to just cryptos, where maybe the good example for that would be like NFTs.

But what that would do would create an additional reporting requirement that would provide the IRS with additional information. Ultimately what they’re trying to do here is match the amount of U.S. dollar value that an entity is receiving based on these reporting requirements to what they’re actually reporting on their tax returns.

What this would honestly do, not necessarily from a revenue-raising standpoint, is this would create a level of additional reporting requirements that quite frankly most of these digital asset businesses don’t have the infrastructure in place, and probably can’t actually provide the information for these transfers. It creates an additional reporting requirement that might not be able to be fulfilled by some of the smaller actors.

These centralized exchanges, these big businesses, that have billions and billions of dollars of revenue can of course abide by these rules. But when you include the definition of digital assets to be so broad, it could have unintended or intended consequences to have this additional reporting requirement that is very, very hard to satisfy for some actors come into play.

Ultimately, at the end of the day, the goal is to raise more revenue. That’s why these amendments are there in the first place. But the consequences of what it can do to the industry are something that need to be considered.

All of these transactions that are over a certain dollar threshold have to be reported, or at least tagged under the Bank Secrecy Act. But that doesn’t necessarily mean it goes directly to the IRS. If that were to go to the IRS, it would give them an additional tool to see and track where there are underreporting potentials for crypto actors.

But again, I think the additional consequences that come into play will definitely stifle innovation in the U.S. and will create an added layer of complexity for businesses in the space.

Ten thousand dollars of crypto is a lot of money. But when you’re doing it in units or in comparison to BTC or Ethereum, it’s really not that much of those assets. It could be 0.2 BTC right now, or it could be 2.5 or 3 Ethereum. A lot of early investors and businesses that are moving funds from time to time, send transactions in very large multiples of those amounts.

What I’m talking about is the amounts on change, the Ethereum or the Bitcoin amount, not necessarily the U.S. dollar amounts. Some people don’t really look at the U.S. dollar amount.

It creates an additional level of complexity, which might have the unintended, or like I said again, intended consequences of hurting the crypto industry in the U.S.

Marie Sapirie: Even more recently than the reporting proposals, on September 13 the House Ways and Means Committee Democrats proposed amending the wash sale rules in section 1091 and the constructive sale rule in section 1259 to include digital assets. These changes aren’t part of the infrastructure bill. They’re in the $3.5 trillion reconciliation bill.

This is another area where there have been discussions about whether and how the rules apply for at least a few years, but the legislative text is new. Could you tell us about the potential impacts of these proposed changes?

Jordan Bass: There are definitely a lot of participants in the market who the constructive sale rule will apply to them more so. The wash sale rules will be applicable to many more actors.

But the constructive sale rule potential change would effectively make it so that some individual actors and traders can’t really hedge their positions as much as they have been. Because they’re treating these tokens effectively as securities.

As of now, it’s personal property. Trading property is a lot different than trading securities and that’s why some of these rules are not necessarily applicable. That will have an impact on the hedging aspect of a lot of individuals that are taking these positions on the constructive sales side.

But more importantly, a lot of people are harvesting their tax losses when the crypto markets are maybe in a downswing or they bought the local top in the middle of this year or earlier this year, and they’re sitting in a Bitcoin position that they purchased at $60,000 and right now it’s underwater.

At the end of the year, in theory, they’re still long-term bullish. Just like the same people that are hedging their position might still be long-term bullish, but they want to make sure that they can minimize their tax liability. These people that are still long-term bullish on BTC, or maybe it’s a more of like a different sort of token, like another DeFi protocol or it could be a Ethereum or it could be some other token that has utility that they’re looking to invest in. They think the price will appreciate over time. But right now they’re sitting in a large unrealized loss position and they want to offset some of the other gains that they had in the year.

They sell that asset and they buy it back immediately, maybe in the same year, maybe in the next year, but within the 30-day period. They do that because they can harvest the loss. They can reset their tax basis, their adjusted basis in what they’re holding. It’ll reset their holding period as well. But like I said, they’re long-term bullish so they’re still planning to hold long-term. They just want to harvest the loss.

That proposal is obviously not taking in theory this wouldn’t happen until 2022, so people would still have the ability to do that at the end of the year. A lot of individuals specifically on my side, as a tax practitioner and legal counsel to a lot of clients, engage in that activity. Because they’re taking advantage of the ability to recognize losses in the space to offset some of the gains they’ve had either earlier in the year in the space or in other capital activity they’ve had for the year.

Getting rid of that will for sure minimize the ability for individuals to minimize their tax liability at year-end in crypto. If they’re looking to reinvest in that asset, they’ll have to wait a period of time. In the crypto space, that could be 30 days, 20 days, 10 days, 60 days, it doesn’t really matter. It could be five days. Prices could appreciate 50, 60, 75 percent or more.

Maybe that will cause people to not sell off their assets at year-end, because they want to just maintain their position in hopes that the price will appreciate again and get back to where they entered or maybe in excess of that. But what that does for a lot of people, and this is a good time to highlight what happened to a lot of people in 2017, is they had a lot of trading activity throughout the year, and the prices were appreciating all throughout the year.

November and December comes and there’s this crazy bull run. People are getting 2, 5, 10 times return on their investments in the matter of days or even weeks. They’re selling and selling, and then at the end of the year, the price starts to come down a little bit. They think that the price is going to go back up, but the price has come down significantly. There’s been like a 30 or 40 percent drawdown from December 15 to December 31. They hold.

Had they sold, they could recognize some losses and buy back later the next day, but they can’t do that anymore. What happened to a lot of people is they held, held, and held. They had all these gains that they recognized throughout the year.

By the time their tax liability became due on April 15, their portfolio had drawn down significantly to the point where their portfolio value was less than what their tax liability even was, because that’s how dynamic this market is.

It can change so drastically up or down. That was before a lot of the infrastructure had been built out like it is today. Maybe we won’t see as volatile of swings, but we see it all the time. It even happened a couple of weeks ago.

Had that person engaged in some harvesting of their tax losses at the year-end, but still believed in those projects, like they thought they did, they could have recognized losses to offset the initial gain that they had and minimize the tax liability. If they still were holding onto the assets all the way through the draw down of 30, 40, 60, or 75 percent, they still might have been in the situation where they didn’t have a portfolio value that was even in excess of their tax liability.

But at least their liability would have been brought down. However, now that can’t be done after this year potentially, so that strategy would effectively be moot. But there is some open to interpretation aspect of this because what is deemed to be substantially identical when we’re talking about digital assets.

There’s Bitcoin, but then on the Ethereum blockchain, maybe there’s Wrapped Bitcoin. Are those substantially identical? Probably, but they are different assets. They are on two different blockchains.

Maybe you could sell your BTC for Ethereum and then purchase Wrapped BTC within that timeframe. Is that considered a wash sale? We don’t know. That’s where we need further guidance on issues like that.

But the wash sale rules will affect a lot more people in the U.S. than the constructive sale rules for sure. They both are very, very important to keep an eye on and see if that’s something that will be finalized and actually put into play.

Marie Sapirie: Well, thank you, Jordan, for joining the podcast today.

Jordan Bass: Thank you so much for having me.