Cryptocurrency: Next Frontier for Cost-Basis Reporting

US personal tax day, April 17, was either the beginning of a lot of heartache or overdue operational relief for investors in cryptocurrency.

Investors who haven’t paid the right amount of taxes for profits earned during the cryptocurrency boom could face fines and audits from the Internal Revenue Service. Alternatively, they could also benefit from some help from broker-dealers and exchanges that decide to voluntarily embrace cost-basis reporting for digital currencies.

Two tax technology firms Scivantage and Wolters Kluwer have just announced they will expand their reach in cost-basis reporting services beyond stocks, bonds and options to cryptocurrencies traded on exchanges and through broker-dealers. The Jersey City, New Jersey-based Scivantage has adapted its Maxit cost-basis platform, while Minneapolis-based Wolters Kluwer is accommodating cryptocurrencies on its GainsKeeper platform.

Neither Scivantage nor Wolters Kluwer would provide the names of any broker-dealers or exchanges using their platforms for cryptocurrencies which make cost-basis calculations based on transactional data from back-office systems. Scivantage says it has signed up one broker-dealer while Wolters Kluwer says it is in talks with multiple broker-dealers. Both firms are counting on surging investor interest and regulatory intervention to prompt exchanges and broker-dealers to offer cost-basis reporting services for cryptocurrencies.

Unlike the case with stocks, bonds or options, the IRS doesn’t require broker-dealers or other financial intermediaries to provide investors with the cost basis or original value of their trades. Without a comparable 1099-B form for cryptocurrencies, investors are left to do the math on their own. That’s a tough task because the original value might not always match the purchase price of the cryptocurrency and the IRS has provided little guidance on how cost-basis and taxes on cryptocurrency investments should be calculated.

In 2014 the IRS defined cryptocurrency as property. However, all that means is that investments are subject to short- and long-term capital gains tax. The lack of further clarity is causing investors and even the most experienced tax advisors and attorneys plenty of angst, because the IRS still wants its fair share of taxes. It isn’t concerned about all the administrative work involved in making the right calculations and doing one’s best won’t be enough to avoid an audit or penalties.

In late March, the IRS warned taxpayers to report cryptocurrency transactions on their tax forms or face stiff financial penalties for not paying the correct amount of taxes. In 2016, the tax agency won a legal battle to require the US’  largest cryptocurrency exchange Coinbase to give it the names of an estimated 14,000 investors on the exchange between 2013 and 2015. At most, only 900 investors reported capital gains for Bitcoin investments during each of those tax years, said a judge ruling in favor of the IRS. Investors on other cryptocurrency exchanges could face the same fate, predict legal experts.

Tax accountants tell FinOps Report that they have been inundated with calls from bewildered investors eager to pay any fee for calculating their taxes from cryptocurrency trades. Requests for extensions in filing their 2017 tax forms have become commonplace.

So far, retail investors have dominated the cryptocurrency market, but analysts predict that institutional investors might follow suit once governments and central banks clarify how the new asset class is regulated. Bitcoin, the world’s largest cryptocurrency, has skyrocketed to more than US$9,000 a coin, its highest price since March when the market briefly tanked as investors sold their investments to pay taxes.

A new study from fintech research firm Autonomous NEXT shows that 226 global hedge funds are now trading cryptocurrencies. “Hedge funds involved in either statistical arbitrage or long-short strategies will want to capitalize on the volatile cryptocurrency market,” predicts Robert Dykes, chief executive of Caspian, a San Francisco-based operator of a front-to-back office trade execution and portfolio management platform for cryptocurrencies.

He says that 75 hedge funds are interested in using Caspian’s trade execution platform, which consolidates bid and ask data from multiple cryptocurrency platforms. As active traders, hedge funds will likely prefer direct access to cryptocurrency exchanges rather than use intermediaries.

Fuzzy Math

Coinbase says that it will provide investors holding cryptocurrencies worth over US$20,000 in value with a Form 1099-K for 2017. However, unlike Form 1099-B used for stocks, bonds and options, Form 1099-K does not provide any cost-basis information. It only indicates the date and amount of payments to investors made. Coinbase did not respond to requests seeking comment.

“There are three bits of information investors need to calculate their capital gains profit or loss,” explains Adam Bergman, a tax partner with IRA Financial Group, a retirement planning consultancy in Miami, whose clients have invested in cryptocurrencies for their retirement accounts. The cost-basis of the investment, the length of time the investment is held and the sales price must all be used.

“Exchanges are offering different levels of information for cryptocurrency transactions,” says Stevie Conlon, a vice president, tax and regulatory counsel for Wolters Kluwer. “Investors buying and selling cryptocurrency on a single exchange might not have trouble doing the cost-basis calculations on their own if they have a limited number of transactions.”

That’s not the norm. Most cryptocurrency investors are active traders, executing dozens if not hundreds of trades on multiple exchanges each year and not always in US dollars. “The challenge in calculating taxes takes place when investors exchange one cryptocurrency for another, trade on multiple exchanges, deal with forks, or use private wallets,” says Conlon. “In addition, different tax rules could apply to different cryptocurrencies or tokens.”

The IRS says that investors exchanging one cryptocurrency to another are subject to capital gains taxes. However, some tax advisors disagree, arguing that “like-kind” exchange rules can be used for tax years before 2018 to avoid recognizing taxable gain. “If gain is deferred, cost-basis adjustments must be made for the cryptocurrency received,” says Conlon.

When it comes to the receipt of new cryptocurrencies in fork transactions, the cryptocurrency equivalent of corporate actions, the tax agency has never clearly explained how investors should be taxed.  Tax advisors are concerned that some types of forks could result in ordinary income when prior cryptocurrency holdings are retained and only new coins are received. Such forks occurred with Bitcoin twice in 2017. In August 2017 each investor in Bitcoin received the right to one Bitcoin Cash. In October 2017 each investor in Bitcoin received the right to one Bitcoin Gold.

When in doubt about cryptocurrency forks, paying taxes based on ordinary income is the safest bet, recommends Conlon. Even so, it is unclear how to calculate the tax as ordinary income. That is because there is no guidance from the IRS about whether cost basis should be applied to the new currency received.

Unlike the case with stocks, bonds, and options, the IRS hasn’t even explained which methodology should be applied for calculating cost basis for cryptocurrency sales. Is it the first-in, first-out method or another accounting convention such as lowest-in, first-out. Or what about specific lot identification? Some tax advisors believe that the IRS will only accept the specific lot identification methodology, while others say that it is up to the investor as long as a consistent methodology is used for all transactions.

Private Wallets

The most difficult challenge facing investors in cryptocurrencies, agree tax accountants, will likely be handing off-exchange transactions — or transfers of cryptocurrency from exchanges into what are known as private wallets. Why? Cryptocurrency exchanges have no record of these transactions which take place after an investor sells the cryptocurrency and deposits it in a digital form of a safe deposit box where only the investor holds the key. Although investors benefit from the safety and convenience of private wallets, they struggle with keeping track of all their subsequent transactions required for tax purposes.

Some cryptocurrency tax packages claim to help investors do tax calculations themselves but their functionality varies. So do results, which the firms don’t guarantee. “The calculations aren’t always accurate, and might not accommodate private wallets or all of the methodologies for calculating cost-basis,” says cryptocurrency investor David Deputy, president of the trade group Accounting Blockchain Coalition in New York.

Retail tax software packages for cryptocurrency investments, explains Deputy, rely on bucketing pools of cryptocurrency into the same purchase date and price. The cost basis is then calculated based on the first-in, first-out methodology. However, tax software might not always be able to transfer the methodology when investors move cryptocurrencies into their private wallets.

“The software I used moved forward with incorrect calculations,” says Deputy, who is also director of strategic development for corporate tax technology firm Vertex in King of Prussia, Pennsylvania. His solution: downloading the transaction information from exchanges and integrating his private wallet transactions onto a spreadsheet to manually calculate the tax owed.

Scivantage and Wolters Kluwer say that their software can handle transactions in multiple cryptocurrencies, cryptocurrency forks and multiple methodologies for calculating cost-basis based on investor choice. Wolters Kluwer says it also has plans to track cost basis for cryptocurrency investments held in a private wallet. Its GainsKeeper platform can interface with private wallets.

Do it Yourself?

What’s an investor to do to ensure the correct calculation if its broker-dealer or exchange doesn’t use either Maxit or GainsKeeper? The answer seems to be to try its best and hope it is right. Bergman recommends that investors keep manual records of all of their transactions on exchanges, through broker-dealers or through private wallets. The data must include the purchase dates and prices as well as the sales dates and prices.

Given that the IRS requires investors to pay taxes on cryptocurrency investments, it’s likely the agency will eventually provide more clarity about the reporting responsibilities of broker-dealers and exchanges selling the currencies. Investors would still be liable for paying their fair share of taxes. However, they might be comforted to know that the threat of IRS penalties is motivating their broker-dealers and exchanges to do the cost-basis calculations correctly.

Cameron Routh, commercial director at Scivantage, is optimistic that broker-dealers will eventually step up to offering cost-basis reporting on their own. “Brokerages have decades of customer-support experience which leads to a better understanding of the true costs of unsatisfactory customer service,” he says.

Others aren’t as certain. Scott Schirick, a partner with the law firm of Pryor Cashman in New York, warns that investors shouldn’t count on their cryptocurrency exchanges or brokers to provide any cost-basis information unless they are legally compelled to do so. The costs for adapting the technology far outweigh the benefits. There is, however, one notable exception: “Cryptocurrency trading platforms, which become registered with the Securities and Exchange Commission as broker-dealers or alternative trading systems, might offer cost-basis reporting as a preemptive step before the IRS decides to mandate it,” he says.

How soon will the IRS take action? “Clarifications on cryptocurrency taxation are likely lower on the list of the IRS’ priorities due to the enactment last December of the Trump Administration’s tax reforms,” predicts Conlon. “In addition, there are some aspects of taxation of cryptocurrency transactions that require changes in legislation rather than interpretations by the IRS.” Such would be the case with “small transactions” or some types of forks.