On June 28, 2024, the US Treasury Department had released the first of what will “likely” be a few different sets of final regulations relating to digital assets. According to an extensive update from Taxbit, for the most part, this set of finalized rules addresses the implementation of tax information reporting for crypto by digital asset brokers.
However, Taxbit pointed out that tucked away in those final regulations are also some key changes to “substantive” tax rules governing how taxpayers track and account for which unit of crypto is being “sold in any particular transaction.”
Taxbit further noted in a blog post that brokers need to know these rules so they can comply with “reporting requirements, but companies disposing of digital assets are ultimately responsible for following these rules when filing their tax returns.”
Taxbit has recently provided some historical context for tracking the cost basis of digital assets, and they also break down in detail what the new cost-basis tracking regulations mean, and discuss how Taxbit’s enterprise-grade digital asset accounting platform helps clients with staying “compliant with the updated regulations.”
As explained in the update from Taxbit, cost-basis accounting for digital assets has always been “unclear.”
The firm added that companies holding digital assets were faced with three questions when tracking which digital asset unit “was disposed of for cost-basis accounting” purposes:
- Asset pooling – Can holdings be bucketed into a single (universal) bucket, or must they be tracked in separate buckets (based on the specific accounts or wallets where the assets are located)?
- Lot-relief method – Regardless of how the holdings are bucketed, what methods are available for deciding which units are sold—longest-owned, highest cost, or can any unit be selected?
- Timing of my selection – When does the unit disposed of need to be identified — at the moment of the disposal or possibly after the end of the year when preparing a tax return?
Prior to October 2019, there was no guidance from the IRS (internal revenue service) regarding these three questions, “leaving companies to adopt a variety of approaches.”
In 2019, as part of its virtual currency FAQs, the IRS provided some guidance addressing the first two questions.
That guidance focused on two different methods.
Under the default method, a company was required to “pool all of the assets into a single bucket (universally) regardless of where the assets were actually held (in various custodial accounts or non-custodial wallets).”
This universal-pooling approach then “required taxpayers to dispose of units in chronological order from oldest acquisition to newest–known as first-in, first-out (FIFO).”
Under this approach, a company might dispose of a unit “held on exchange A, but could be required under FIFO to use the cost basis of a unit that was actually held on exchange B.”
The second method was “elective.”
It allowed a company to segregate units into buckets based on “where they were held (account or wallet), but permitted the company to specifically select which unit was being sold from that account or wallet.”
This approach was rarely used to its fullest extent—taxpayers deciding which unit is “sold for every separate sale—but was often employed with a programmatic approach such as highest in, first out (HIFO) that was designed to reduce taxable gains.”
Under this approach, a taxpayer disposing of a unit on exchange A could only select to apply cost basis from the units held on exchange A.
Treasury’s new regulations provide clarity by answering all three questions.
Under the new rules, universal (global) pooling is no longer permitted. Digital-asset holdings “need to be bucketed by account or wallet. A unit disposed from account A cannot be assigned cost basis from a unit held in wallet B.”
According to the update from Taxbit, this is a significant change from historical practice where “most companies had defaulted to a Universal FIFO approach as described above.”
If this is the approach your business has taken historically, then you need to prepare to “update your strategy.”
TaxBit also mentioned in its extensive update that companies have the ability to continue to use “programmatic approaches when selecting the lot being disposed of and calculating the resulting gain or loss.”
Finally, the new rules require a company to “select which lot is being disposed of at or before the time of disposal.”
These selections need to be “documented in real time” during the tax year.
In other words, companies can “no longer wait until the tax year is over and then determine their lot-relief methodology after the fact.”
Tracking these decisions during the year and maintaining “adequate records are massively important because failure to do so could result in unsupportable realized gain/loss calculations and IRS scrutiny during audit.”
As digital asset regulations evolve, Taxbit’s enterprise-grade digital asset accounting platform is designed to “help businesses seamlessly adapt to these changes.”
The most critical change in the new regulations is the “shift from universal (global) to by-account or by-wallet pooling.”
Taxbit’s platform handles this new requirement.
It automatically segregates assets “by account or wallet, keeping an accurate inventory of all transactions and holdings in real-time.”
Whether you hold Bitcoin across multiple wallets or exchanges, “each wallet’s assets will be tracked individually, ensuring compliance with the IRS’s requirements for by-account pooling.”
The new regulations clarify, but do not significantly change, the permitted methods for “selecting which cost basis unit is being disposed of.”
Taxbit’s software provides users with “flexible cost basis relief methods including first-in-first-out as a default for the ability to programmatically manage specific identification.”
In addition to source-based FIFO, Taxbit’s tool supports other account-based programmatic lot relief methodologies including, “highest-in-first-out, weighted average, last-in-first-out, and a first-of-its-kind retroactive approach tailored for the needs of organizations that support short positions and need to manage their gain/loss calculations for accurate results.”