IRS Regulation on Digital Assets Cost Basis

IRS Issues New Guidelines for Reallocating Cost Basis of Digital Assets Across Wallets

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On January 1, 2025, new IRS rules regarding the reallocation of cost basis across wallets will come into effect, this regulation will require brokers/exchanges to share cost basis information for all crypto transfer. This includes both broker-to-broker transfers and transfers to non-broker wallets. The guidelines have been introduced with an aim of providing clearer rules for taxpayers who hold digital assets, like cryptocurrencies, in multiple wallets or accounts. New regulation aims at wallet level cost tracking instead of prevailing universal wallet accounting method. This means that starting 01.01.2025, the taxpayers, users, traders, etc. will have to keep a track of cost basis of their transactions per wallet separately, rather than keeping track of all wallets combined/universally.

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Understanding Cost Basis in Digital Assets

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The cost basis of a digital asset is the original value at which the asset was acquired, adjusted for any related costs, such as transaction fees. It is crucial in determining the amount of capital gains or losses a taxpayer experiences when selling or exchanging their digital assets. However, calculating cost basis is challenging when multiple wallets and trading platforms are being maintained by the cryptocurrency owners.

In this regard, IRS has issued Safe Harbor Rules for reallocating cost basis. The said rules are discussed hereinbelow.

Safe Harbor for Reallocating Cost Basis

The IRS’s Rev. Proc. 2024-28 introduces a safe harbor for reallocating the unused cost basis of digital assets. This provision allows taxpayers to allocate their unused basis (the portion of the purchase price that has not been fully recognized in previous sales) across wallets as of January 1, 2025.

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Here are the key highlights of the safe harbor provisions:

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1. Wallet-by-Wallet Reporting: Under the new rules, taxpayers are required to report the cost basis of digital assets on an account-by-account or wallet-by-wallet basis. This is a shift from previous practices where some taxpayers used a universal approach to tracking the basis across multiple wallets or exchanges.
2. Allocation Methods: New regulation has provided two options for the tax payer (1) Specific unit identification and (2) Global Allocation
   
   • Specific Unit Identification: Taxpayers can allocate specific units of unused basis to specific units of digital assets within a wallet. This requires detailed tracking of the purchase date, price, and other unique identifiers.
   • Global Allocation Method: This method enables taxpayers to apply a more generalized approach, allocating basis across multiple wallets using factors such as the highest basis or earliest acquisition date. This method is useful when precise tracking of individual units is not possible.
3. Record-Keeping Requirements: To take advantage of the safe harbor, taxpayers must maintain accurate records of their digital asset transactions, including details of when the assets were acquired, the price paid, and which assets were sold or transferred. This is critical for compliance and will help ensure that taxpayers can substantiate their cost basis if audited.
4. Irrevocability of Allocations: Once a taxpayer has made an allocation of their unused basis under the safe harbor, that decision is irrevocable. This means that careful consideration must be given when choosing the allocation method, as it cannot be changed after it has been reported to the IRS.
5. Restrictions: The safe harbor does not apply to digital assets acquired after January 1, 2025, nor does it resolve disputes over the availability or amount of basis that are under litigation or IRS examination.

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Practical Examples of Safe Harbor Use

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The IRS provides several examples in Rev. Proc. 2024-28 to illustrate how the safe harbor can be applied. For instance:

A taxpayer holds digital assets in two wallets, XYZ Wallet and GHI Wallet. If the taxpayer sells a portion of their assets before January 2025, they need to allocate their unused basis to the remaining assets held after that date. By keeping detailed records, they can either apply a specific unit allocation or choose a global allocation based on the highest basis or earliest acquisition date.

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FIFO and Specific Identification for Digital Assets

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If a taxpayer cannot or does not use specific identification for the digital assets they sell or exchange, the IRS will automatically apply the FIFO (First-In-First-Out) method. Under FIFO, the oldest units are considered sold first, which may lead to higher taxable gains if the value of digital assets has appreciated over time.

However, taxpayers may avoid FIFO by using the specific identification method, provided they can identify the specific digital asset units being sold and maintain adequate records to support that identification. This method is particularly beneficial for taxpayers who wish to sell digital assets with a higher cost basis, thereby reducing their taxable gains.

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Compliance Challenges and Benefits

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For many cryptocurrency holders, this transition to account-based reporting may pose initial challenges. The requirement to track and report the cost basis separately for each wallet or account could complicate tax filings, especially for those using multiple platforms to trade or hold assets. Taxpayers who have been using a universal approach to basis allocation will need to update their record-keeping practices to comply with the new rules.

However, the safe harbor and other guidelines are expected to provide long-term benefits by reducing ambiguity around the taxation of digital assets. By clarifying how the cost basis should be calculated and allocated, the IRS aims to improve compliance and ensure that taxpayers are accurately reporting gains or losses from digital asset transactions.

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What steps should be taken before January 1, 2025

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With the new rules coming into effect on January 1, 2025, taxpayers should take the following steps to prepare:

1. Review Digital Asset Holdings: Taxpayers should review all digital assets held in different wallets or accounts to determine the cost basis of each asset.

2. Update Record-Keeping: Ensure that records for all digital asset purchases, sales, and transfers are up to date and include details like acquisition dates, purchase prices, and transaction fees.

3. Choose an Allocation Method: Decide whether to use the specific unit identification or global allocation method for reallocating the cost basis, based on the availability of detailed records.

4. Consult a Tax Professional: Given the complexities of these new rules, taxpayers may want to consult with a tax professional or financial advisor who specializes in cryptocurrency to ensure compliance and optimize their tax strategy.

Link:

https://www.irs.gov/newsroom/treasury-irs-issue-final-regulations-requiring-broker-reporting-of-sales-and-exchanges-of-digital-assets-that-are-subject-to-tax-under-current-law-additional-guidance-to-provide-penalty-relief-address

https://www.federalregister.gov/documents/2024/07/09/2024-14004/gross-proceeds-and-basis-reporting-by-brokers-and-determination-of-amount-realized-and-basis-for