You spend weeks pouring over your transaction history, trying to make sure that your tax return is accurate. Despite your best efforts, you end up getting a warning letter from the IRS saying that you owe thousands of dollars in unpaid taxes.
It might sound like a bad dream, but just a couple of years ago, this nightmare scenario actually happened to thousands of cryptocurrency investors. And, because of short-sighted regulations drafted hastily by American politicians, it’s likely to happen again in the near future on a much bigger scale.
Form 1099-K: A Short History
In the past, there were no clear guidelines dictating what tax forms bitcoin exchanges were required to send to their customers. As a result, different exchanges chose different approaches to tax reporting.
Coinbase and other exchanges chose to send Form 1099-K to customers (and to the government) if customers hit a certain threshold of trade value and number of trades. Of course, there was a problem. These forms were designed to be used by credit card companies, not cryptocurrency exchanges. As a result, all of the trader’s transactions (even the ones that were non-taxable) were reported on the form.
This ended up causing a nightmare for taxpayers, as the IRS was being notified that certain taxpayers transacted with hundreds of thousands of dollars of cryptocurrency. The IRS ended up sending thousands of warning letters to investors, many of whom had gone through painstaking efforts to accurately report their taxes.
To their credit, large exchanges seem to have learned from their mistakes. Because of the confusion that these forms caused, Coinbase and Gemini have since stopped issuing them to customers. Unfortunately, it doesn’t appear that the federal government learned the same lesson.
How The Infrastructure Bill Will Lead To A Tax Reporting Nightmare
In the near future, taxpayers are going to run into an even bigger tax reporting issue. This time, it won’t just be a few thousand people who receive a 1099-K. Because of the 2021 infrastructure bill, these issues will now impact every investor trading and transacting with bitcoin.
While the infrastructure bill didn't change how bitcoin is taxed, it did change what bitcoin brokers like Coinbase or Binance are required to report. Just like stockbrokers, they’ll be required to issue 1099-B forms to customers and the IRS.
At face value, this may seem like a positive development for the ecosystem. Since exchanges will have clear requirements for what tax forms to send customers, we might avoid issues stemming from a lack of regulatory clarity. Unfortunately, a closer look at the situation shows that this bill likely presents more problems than solutions.
While exchanges will be required to report the total amount of fiat you made (proceeds) from bitcoin trades, they won’t know how customers originally got their coins or how much money they invested (cost basis). Since transferring bitcoin between wallets and exchanges is so common, it’s likely that we’ll see tax reporting problems.
For example, imagine that you transfer your money from your personal wallet to Coinbase, or from Binance to Coinbase. Then, you sell your bitcoin for $50,000.
In both of these situations, Coinbase won’t know your original cost basis. However, Coinbase will still be required to file Form 1099-B with the IRS.
On Form 1099-B, it’s likely that Coinbase will report the proceeds from your trades but will either leave the basis blank or put “unknown.” So, if you sell your bitcoin for $50,000, the IRS might hold you responsible for $50,000 worth of gains (even if you originally bought your coins for $40,000).
These are the same issues that accompanied Form 1099-K in previous years. Again, this will likely lead to bitcoin investors receiving warning letters about their unpaid tax liability, even when they accurately filed their tax returns.
Because of the infrastructure bill, taxpayers will be required to keep detailed records on all of their cryptocurrency purchases and transfers. If these records aren’t kept, the IRS will likely require all proceeds made from cryptocurrency disposals to be picked up as income in the case of an audit.
Form 1099-B Works For Stocks, Not For Bitcoin
Some investors have trouble understanding why Form 1099-B would cause such major issues. After all, stockbrokers like Robinhood and E*Trade are already required to issue these forms to customers. Still, the vast majority of stock traders are able to easily report their gains and losses during tax season.
It’s important to remember that bitcoin is fundamentally different from stocks and securities. Bitcoin is designed to be easily transferable, whether you are sending it to a friend or family member, holding it on a cold wallet or trading it on a decentralized exchange.
While stockbrokers can easily share information with one another about transfers and disposals, it’s hard to see how cold wallets and decentralized entities can do the same. Unfortunately, the infrastructure bill seems to be ignoring the differences between cryptocurrencies and equities.
Misguided Tax Regulations Hurt Bitcoiners
It’s disappointing to see that the United States has attempted to regulate the new financial system with the same rules that governed the old one. In doing so, regulators completely ignored the benefits that decentralization could bring to Americans all across the country.
The infrastructure bill won’t have a negative impact on companies like Coinbase and Kraken. Instead, it will hurt bitcoin investors who store their holdings on cold wallets and wish to opt out of the predatory financial system. Now, it’s likely that their tax reporting will become more difficult and complex than ever before.
This is a guest post by Miles Brooks. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.