Decrypting DeFi: Navigating Tax Rules for Cryptocurrencies

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Cryptocurrencies have gone from an unknown quantity to the “must have” investment. Investors are lining up to invest in Bitcoin, Ethereum, Doge, etc. This surge has helped the creation of DeFi (Decentralized Finance), a separate financial system which lives and interacts on the blockchain. This rise has not gone unnoticed by the U.S. Treasury Department and Congress, and both institutions have taken steps to ensure cryptocurrency transactions are reported and taxed, including the passage of the Infrastructure Investment and Jobs Act.

At the heart of the government’s guidance on cryptocurrency taxation is Notice 2014-21, which established that cryptocurrencies (and by inference their derivatives) are property. Thus, the purchase or sale of a coin or token is considered the purchase or sale of property, as opposed to being a currency like the U.S. dollar. Exchanging one coin or token for different coin or token is considered a taxable sale of those coins or tokens. When a coin or token is sold, the holder has a taxable gain equal to the amount of money or the fair market value of the property received for the coin or token less the holder’s basis in the coin.

Beyond trading, many investors dip their toes into mining cryptocurrency. Mining is the process by which new coins are created. At an extremely high level, miners deploy compute power to solve complex mathematical equations, or cryptographic hashes, which in essence facilitate the verification of transactions on the block chain. The miners who accomplish these tasks the fastest are rewarded with a coin. A miner’s receipt of a mined coin is taxed as ordinary income in an amount equal to the coin’s fair market value at the time it is received.

DeFi expands the types of transactions that can be undertaken with cryptocurrency by using cryptocurrency to effectuate typical financial transactions. For instance, investors can lend or borrow coins, short coins, or earn interest on their coins through a “staking” process or lending transaction. Each transaction has the potential to generate taxable income, through interest, fees, or realized appreciation. DeFi makes these transactions easier for parties to enter into, as compared to the traditional financial system. For instance, DeFi transactions do not require credit checks, social security numbers, or a bank account, and can be completed with a few clicks of a button.

Cryptocurrency transactions are recorded on the blockchain, a digital ledger of transactions that is duplicated and distributed across a network of computers. The blockchain generally does not contain personal information, making the transactions fairly anonymous. This has raised concerns with lawmakers as to whether cryptocurrency is used to fund terrorism or facilitate illegal activities in addition to whether the transactions are being reported for income tax purposes.

Davis Miles Referral

In response, the government has sought more information on these transactions to enforce tax collection. In its FAQ, the IRS has clarified virtual currency payments are subject to information reporting (such as Form 1099) like any other payment made in property. In 2018, the IRS identified virtual currency transactions as one of its five major compliance campaigns, and in 2019 it began sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax. In 2020, Form 1040 included a specific question regarding cryptocurrency transactions.

Recently, the Infrastructure Investment and Jobs Act began requiring cryptocurrency brokers to issue Forms 1099-B to their customers and the IRS beginning in 2023. This means cryptocurrency brokers are required to disclose the names, addresses, and phone numbers of their customers, the gross proceeds from sales and any capital gains or losses. The definition of “broker” in the law is broad. It includes any entity that provides a service “effectuating” the transfer of digital assets, meaning that crypto miners and software developers could be considered “brokers” and be required to report information they may not have access to. Additionally, the reconciliation bill making its way through Congress includes proposals to bring cryptocurrencies under the constructive sale rule and the wash sale rules.

Given this new focus on information gathering and enforcement, investors need to make sure they keep accurate records of their cryptocurrency transactions, including when a coin or token was purchase or sold, or received as fee or interest income, and its value at the time of the purchase, sale or receipt. Investors should engage a tax professional who is knowledgeable about cryptocurrency to ensure their transactions are properly reported.

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