The IRS believes that crypto tax evaders are cheating the IRS out of at least $50 billion a year. The IRS treats cryptocurrency as “property” and requires that if one buys, sells, or exchanges cryptocurrency, any income or gains would need to be reported on IRS Form 1040. On August 25, 2023, the IRS released proposed regulations on the sale and exchange of digital assets by brokers. Under the rules, brokers would be required to use a new form to simplify tax filings and cut down on tax cheating.
The proposed crypto broker rules are expected to go into effect in 2026 to reflect sales and exchanges carried out in 2025. Written comments on the crypto broker proposal are being accepted through Oct. 30, with at least one public hearing to be held after that date.
- The proposed rule would require crypto brokers to file a new IRS form
- The impetus of the rule is that the IRS feels it’s losing out in billion of tax revenue
- When investing with a Self-Directed IRA, there are no taxes to worry about until you take a distribution (or never when using a Roth)
Proposed Broker Crypto Reporting Rule
Under the proposed IRS rule, cryptocurrency brokers, including exchanges and payment processors, would have to report new information on users’ sales and exchanges of digital assets to the IRS starting in 2026. The rule is a clear push by the IRS to prevent crypto users from failing to report capital gains tax from crypto transactions. This proposed rule places the reporting obligations squarely on the shoulders of the brokers, crypto exchanges, and payment processors versus the individual crypto investor, which is already required to report their crypto trading gains on Schedule D of IRS Form 1040.
Under the proposal, the definition of a “broker” would include both centralized and decentralized digital asset trading platforms, crypto payment processors and certain online wallets where users store digital assets. The rule would cover cryptocurrencies, like Bitcoin and Ether, as well as non-fungible tokens (NFTs). Brokers would need to send the forms to both the IRS and digital asset holders to assist with their tax preparation.
The inclusion of decentralized crypto platform or Defi in the definition of crypto exchange platforms that would be subject to the proposed broker crypto reporting rule is very controversial and could severely curtail the future growth of decentralized exchanges, which have been popular because of its lack of IRS reporting characteristics.
This rule forms part of a broader initiative by Congress and regulatory bodies to tighten regulations on crypto users potentially evading tax payments. A new tax reporting form labelled Form 1099-DA is envisioned to aid taxpayers in determining their crypto tax liabilities,
The requirements stem from the one trillion dollar 2021 Infrastructure Investment and Jobs Act, which incorporated a provision aimed at augmenting tax reporting obligations for brokers dealing with digital assets. The IRS was tasked with detailing the criteria for classifying crypto brokers and providing corresponding reporting forms and instructions. In addition, the rule extended reporting prerequisites to digital assets for specific cash transactions exceeding $10,000.
If passed, this crypto broker rule is projected to generate approximately $28 billion in revenue over a ten-year span. The Treasury has proposed that these regulations take effect for brokers in 2025, in preparation for the 2026 tax filing period.
Why Buy Crypto in a Self-Directed IRA?
In general, for one to hold Bitcoin and other cryptocurrencies with an IRA is via a Self-Directed IRA. Banks and brokerage firms do not allow individual retirement account owners to invest and hold cryptos directly. The main advantage of using a Self-Directed IRA to purchase Bitcoin is to gain exposure to an emerging asset class and be able to lock in any potential gains tax deferred or tax-free in the case of a Self-Directed Roth IRA.
Since most investors are looking to invest in cryptos for the long-term, and are not focused on using them as a digital currency or to day-trade, using a Roth instead of personal savings makes a lot of tax sense.
The IRS tax treatment of virtual currency has created a advantageous tax setting for retirement account investors. In general, when a Self-Directed IRA asset generates income or gains from the purchase and sale of a capital asset, such as stocks, mutual funds, real estate, etc., irrespective of whether the gain was short-term (held less than twelve months and subject to ordinary income tax rates) or long-term (held greater than twelve months subject to capital gains tax rates), the IRA does not pay any tax on the transaction and any tax would be deferred to the future when the retirement account holder takes a distribution. Thus, using retirement funds, especially a Roth, to invest cryptos would permit the investor to defer or even eliminate any tax due from the investment.
With almost 90% of retirement accounts being invested in equities, diversifying one’s retirement assets into other assets, such as real estate and cryptos, is a popular strategy for many savvy investors. The thought process is that you don’t want to put all your eggs in one basket. Spread yourself across many different asset classes for ideal diversification, including new and exciting ones.
Risk vs. Reward
Cryptos are very volatile, especially Bitcoin, but with volatility comes the potential for huge gains. For example, Bitcoin was at $5,200 on March 15, 2020, and peaked in 2021 at over $60,000 and now sits around $26,000 as of August 2023. It was up almost 250% over the last five years. Many IRA investors believe that using a Self-Directed IRA makes sense since it has a long-term investment horizon which meshes well with the long-term opportunity growth of Bitcoin and many cryptocurrencies.
Proposed Crypto Bill’s Impact on Self-Directed IRAs
The new proposed bill requiring brokers, crypto exchanges, crypto payment processors and certain online wallets where users store digital assets to report new information on users’ sales and exchanges of digital assets to the IRS and the crypto user should increase popularity of the use of a Self-Directed IRA for crypto investments. Since any gains from the sale of cryptos would not be a taxable event, the reporting requirements imposed on brokers by this proposed bill would be less impactful.
In addition, from an investor perspective, the fact that no tax would be due on gains would alleviate any stress involved in calculating one’s tax liability from one or many crypto transactions. A Self-Directed IRA investor would not have to worry about the in the crypto, holding period, or tax rate. It is conceivable that the crypto industry will pivot at some point in the near future to focus more on IRA investors for crypto investments because of its tax-free nature. Reporting would likely still be required for crypto investors using an IRA under the proposed bill, however, the lack of tax revenue to be generated will surely lessen any potential IRS scrutiny on those clients’ crypto accounts.
This proposed crypto broker rules is part of a growing trend by Congress to provide the IRS and Treasury with more oversight and data to help crack down on crypto clients not paying their fair share of taxes on their crypto gains. However, the impact this bill could have on the decentralized crypto exchange could be significant. The IRS has been concerned with the lack of reporting involving crypto transactions via decentralized exchanges and is clearly focused on gaining greater reporting and transparency from crypto investors in this regard. Public comments on this bill have been mixed, but this bill is expected to pass in some form in the coming months. Stay tuned…