The Infrastructure Act passed by the US Congress in 2021 brought cryptocurrency exchanges under the controversial definition of “broker” and made them subject to the IRS information reporting regime. As a result, starting January 1, cryptocurrency exchanges will be required to report their customers’ annual cryptocurrency gains and losses to the Internal Revenue Service, similar to brokerage houses.
The Treasury develops regulations related to the Infrastructure Act. Regulations (commonly referred to as Regs) interpret legislation and give specific guidelines on how to comply with the law. As part of the Regs, the IRS is reportedly working on introducing a brand new tax form called Form 1099-DA for Exchanges to capture individual annual cryptocurrency activity subject to tax. The draft regulations are expected to be released in the coming months and, at this time, the details of the form and the information it will capture are unknown. If passed, exchanges will use the new form to report your cryptocurrency gains and losses to the IRS.
What are 1099s?
A 1099 is a form completed by financial institutions summarizing a customer’s annual taxable activity. There are several types, including: 1099-Bs (brokerage and barter proceeds) issued by stockbrokers to report annual gains and losses from stock transactions; Forms 1099-INT (interest income), which are used by financial institutions to report annual interest income; and 1099-MISC (miscellaneous information) forms that some cryptocurrency exchanges use to report staking and similar types of income.
There are three copies of each Form 1099 – Copy A, Copy 1, and Copy B. The first two are filed with the IRS and the taxpayer’s state, respectively, by the financial institution. Copy B is sent to clients to be filed with their taxes.
For example, suppose you bought a unit of $TSLA for $500 and sold it for $1,200 on Robinhood in 2021. In January of this year, Robinhood was required to file a 1099-B form showing $700 ( $1,200 – $500) capital gains. subject to taxes. Copy A and Copy 1 report this amount to the IRS and your state, respectively. You receive copy B to help you file your taxes.
The purpose of the 1099
Through information reported to the IRS by financial institutions through 1099 forms, the agency knows your annual gains and losses before you file your taxes. If you file a return without including this activity, the IRS can automatically detect the discrepancy and send you a tax notice to correct the error. Thus, 1099 forms help ensure that taxpayers who engage in income-generating activities with financial institutions meet tax obligations.
Currently, there is no dedicated Form 1099 for entering annual cryptocurrency gains and losses. In the absence of a cryptocurrency-specific tax form, some exchanges have used Form 1099-K to report cryptocurrency activity in the past. Some have decided not to issue forms for gains and losses. As a result, the information reported to the IRS by exchanges has long been poor to non-existent.
This has led to lower tax compliance rates among crypto users. Because customers do not receive a form at the end of the year, they mistakenly believe that there is no activity to declare and no tax to pay.
For example, 99% of taxpayers report wage income when they receive a W-2 form (wage and tax return) from employers. Over 80% of stock account holders report capital gains and pay taxes when they receive a Form 1099-B from brokerages summarizing annual capital gains/loss activity. On the other hand, if a third party does not generate a tax form, more than 50% of taxpayers do not comply with taxes. (U.S. Government Office of Accountability)
Form 1099-DA aims to change that by capturing cryptocurrency activity and requiring exchanges to report it to the IRS on an annual basis. It is reasonable to expect that this new form will report the information needed to calculate gains (or losses) such as type of asset, date purchased, date sold, gross proceeds and cost basis.
1099-DA Potential pitfalls for multi-trade users
While information reporting has clearly increased tax compliance in many non-crypto related areas, following the same traditional crypto system can easily create more loopholes or even fail altogether due to decentralization of finance, transfers and self-care.
Fast-growing DeFi exchanges such as Uniswap and dYdX will not be able to issue any form of 1099 because they do not collect so-called Know-Your-Customer (KYC) information (name, address, and social security number) from users. This information is generally required to file any Form 1099 with the IRS and the States.
Additionally, asset transfers between crypto wallets and exchanges are extremely common, compared to the traditional securities world. These transfers between centralized exchanges to/from DeFi and non-compliant foreign exchanges will also lead to incomplete and inaccurate 1099s due to cost basis discrepancies.
Additionally, self-custody is common in the crypto world to ensure the privacy and security of assets. Self-custody assets will also make it more difficult for exchanges to issue full 1099s, as cost basis information is generally not available.
Finally, multi-exchange users will likely get multiple 1099-DAs from different platforms. This can be confusing and will require taxpayers to use crypto tax software to reconcile activity across multiple wallets and exchanges.
If you are a single-exchange user (a shrinking segment of crypto investors), 1099-DAs will likely display all the information needed for you to file your taxes accurately. It will make your tax returns faster, easier and cheaper than they are today.
According to the Infrastructure Act, exchanges are required to follow information reporting rules as of January 1, 2023 and issue 1099-DAs to clients during the first quarter of 2024 for the year of previous tax. But since the rules have not yet been made public and available for public comment, the timeline may be extended by a year.
Expect to see draft Form 1099-DA with proposed regulations in the coming months.