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Are you ready? Guidance is coming.

Almost 5 years to the day Notice 2014–21 was released by the IRS. That notice described how existing general tax principles apply to transactions using “virtual” currency.

Now we are one step closer to receiving actual guidance from the IRS. According to a letter from IRS Commissioner Charles P. Rettig dated May 16, 2019, the agency has “made it a priority” to issue more comprehensive tax guidance for crypto assets including acceptable methods for calculating cost basis, cost basis assignment and the tax treatment of forks.

Why is cost basis a challenge when investing in crypto assets?

In the traditional world tracking cost basis is a relatively straight forward process. Exchanges, brokers and the IRS have a system in place to manage this information on behalf of investors. “Tax Lots” and associated “Cost Basis” is provided on a form 1099-B. Combined with proceeds, taxable capital gain or loss events are automatically calculated and easily populated on form 8949 and Schedule D.

With crypto assets there are particular challenges that make the above process easier said than done. Even though the spirit of notice 2014–21 would suggest that the IRS would want exchanges and investors to apply the above process to crypto assets, the industry in practice has avoided doing so. Here’s why:

For Exchanges

Crypto exchanges often take deposits in crypto assets and the exchanges have no way to know the cost basis of deposits. When these assets are later sold, the exchange will only have information on proceeds. A capital gain or loss cannot be calculated without a cost basis.

Additionally, when crypto assets are withdrawn from an exchange, no “Tax Lot” or “Cost Basis” information is attached to that transaction. Therefore, no report is provided and no information is sent to the IRS.

For Investors

Without reports from the trading venues (i.e. 1099-B forms), the burden for cost basis tracking is left to the investor. In the traditional world investors don’t have to typically do this themselves. Not only are they unlikely to be experienced with the new process but it also becomes increasingly complex across a large number of exchanges on which an investor could trade crypto assets. To make matters even worse, it is often the case that cost basis “lots” can get broken into small fractions (you can sell a tenth of a bitcoin, but you can’t sell a tenth of a share of TSLA, for instance).

For now, exchanges attempt to fulfill a duty to report to the IRS by issuing 1099-K forms or 1099-B forms with only proceeds and the burden of tracking cost basis is still left to the investor.

At the end of the day, the IRS simply wants to collect revenue on capital gains and the investor simply wants to accurately file their tax return. Without a solution for cost basis tracking, without a process for 1099-B reporting, both the investor and the IRS are left in a challenging and costly predicament.

Lukka’s software was designed from the ground up to address the specific challenges for cost basis tracking in the crypto industry. We have helped the industry’s largest funds, OTC & proprietary trading desks, crypto exchanges, administrators and accounting firms to solve this problem. Our crypto-native products connect, standardize, reconcile, process and report audit-ready information within a highly secure SOC 1 Type 2 enterprise-grade infrastructure.

Can we help you solve your cost basis problems? Email us at [email protected]