Treasury and IRS Release Current Guidance and Explanation of Revenue Proposals on Tax Treatment of Digital Assets and Cryptocurrency | Practical Law

Treasury and IRS Release Current Guidance and Explanation of Revenue Proposals on Tax Treatment of Digital Assets and Cryptocurrency | Practical Law

The US Department of Treasury and the Internal Revenue Service issued guidance on the taxation and taxable status of digital assets and cryptocurrency and Treasury issued its explanation of revenue proposals addressing digital assets (Green Book).

Treasury and IRS Release Current Guidance and Explanation of Revenue Proposals on Tax Treatment of Digital Assets and Cryptocurrency

by Practical Law Finance
Published on 21 Jun 2023 • USA (National/Federal)
The US Department of Treasury and the Internal Revenue Service issued guidance on the taxation and taxable status of digital assets and cryptocurrency and Treasury issued its explanation of revenue proposals addressing digital assets (Green Book).
The US Department of Treasury (Treasury) and the Internal Revenue Service (IRS) have issued the following guidance on the taxation and taxable status of digital assets and cryptocurrency:

Green Book: General Explanations of 2024 Revenue Proposals

On March 9, 2023, Treasury issued the Green Book, which includes an explanation of the following fiscal year (FY) 2024 tax proposals (2024 revenue proposals) specific to digital assets and cryptocurrency:
Digital asset mining energy excise tax. According to the Green Book, under the 2024 revenue proposals, any firm using computing resources, whether owned by the firm or leased from others, to mine digital assets would be subject to an excise tax equal to 30% of the cost of electricity used in digital asset mining, and firms that produce or acquire power off-grid would be subject to an excise tax equal to 30% of their estimated electricity costs. The proposed excise tax would be effective for fiscal years beginning after December 31, 2023, and would be phased in over three years at a rate of 10% in the first year, 20% in the second year, and 30% in all subsequent years.
Wash sale rules to apply to digital assets. According to the Green Book, under the 2024 revenue proposals, wash sale rules would apply to digital assets. Currently, Internal Revenue Code (Code) Section 1091 disallows a loss from a sale of stock or securities if the same or substantially identical stock or securities are purchased within 30 days before or after the sale, also known as a wash sale, unless the taxpayer is a dealer in stock or securities and the loss is sustained in the ordinary course of its dealer business. The wash sale rules are intended to ensure that taxpayers cannot recognize losses without exiting their position in a loss asset for a meaningful period of time.
Under the 2024 revenue proposals, the wash sale rules would be amended to add digital assets to the list of assets subject to the wash sale rules. To effectuate this, under the 2024 revenue proposals, the Treasury Secretary would have the authority to:
  • Prescribe regulations defining the term "substantially identical" for purposes of determining whether the purchase and sale of substantially identical digital assets within the 30-day period prescribed in the rules is subject to the wash sale rules.
  • Provide rules for transactions where a taxpayer sells digital assets at a loss and both the taxpayer and a related party then acquire the same or substantially similar digital assets, to issue regulations expanding the definition of "related parties" as necessary to prevent abuse, and to coordinate the wash sale rules with other rules addressing sales of loss property between related parties.
  • Provide an exception to the application of the wash rules for ordinary course of business transactions involving digital assets, not including trading.
Under the 2024 revenue proposals, the Treasury Secretary would have authorities to require brokers to report information as necessary or appropriate to implement the wash sale rules.
According to the Green Book, this proposal would be effective for taxable years beginning after December 31, 2023.
Securities loan nonrecognition rules to include digital assets. Under the 2024 revenue proposals, the current securities loan nonrecognition rules would be expanded to include loans that actively traded digital assets recorded on cryptographically secured distribution ledgers, provided the loan has terms similar to those currently required for loans of securities. The Treasury Secretary would have authority to:
  • Determine when a digital asset is actively traded.
  • Extend the securities loan nonrecognition rules to non-actively traded digital assets.
This specific proposal would be effective for taxable years beginning after December 31, 2023.
Information reporting.
The 2024 revenue proposals would:
  • Require brokers (for example, US digital asset exchanges) to report gross proceeds and such other information as the Treasury Secretary may require for sales of digital assets with respect to customers and, in the case of certain passive entities, their substantial foreign owners. The proposed change would allow the US to share such information on an automatic basis with appropriate partner jurisdictions to reciprocally receive information on US taxpayers that directly, or through passive entities, engage in digital asset transactions outside the US under an international automatic exchange of information framework. This proposal would be effective for returns required to be filed after December 31, 2025.
  • Require individuals and certain US entities to report digital assets maintained in a foreign digital asset account if the taxpayer holds an aggregate of foreign accounts or assets in excess of $50,000. This proposal would be effective for returns required to be filed after December 31, 2023.
Mark-to-market rules to include digital assets. Section 475 of the Code currently requires dealers in securities to use the mark-to-market method of accounting for inventory and non-inventory securities held at year-end, and dealers in commodities and traders in securities or commodities may elect to use the mark-to-market method. The 2024 revenue proposals would add a new category of actively traded assets – digital assets and derivatives on, or hedges of, those digital assets – for which mark-to-market accounting may be used for tax purposes at the election of a dealer or trader.
The Treasury Secretary would have authority to determine which digital assets are treated as actively traded for purposes of the mark-to-market rules, taking into account relevant facts and circumstances. Under the 2024 revenue proposals, a digital asset would not be treated as a security or commodity for purposes of the mark-to-market rules, meaning a digital asset would only be eligible for mark-to-market treatment under the rules applicable to this new third category of assets.
This proposal would be effective for taxable years beginning after December 31, 2023.

Notice 2023-27: Non-Fungible Tokens (NFTs)

On March 21, 2023, the IRS issued Notice 2023-27, which:
  • Provides guidance on the treatment of certain non-fungible tokens (NFTs) as collectibles under Section 408(m) of the Code, which relates specifically to individual retirement accounts (IRAs). Under Section 408(m), the acquisition by an IRA of a collectible is treated as a distribution from the IRA equal to the cost to the IRA of the collectible. Code Section 408(m)(1) also provides that the acquisition of a collectible by an individually directed account under a qualified plan under Code Section 401(a) is treated as a distribution from the account equal to the cost to the account of the collectible. The constructive distribution is taxable, making collectibles generally unsuitable investments for retirement plans. The IRS has not previously addressed NFTs in any of its limited cryptocurrency guidance, including Notice 2014-21, which treats convertible cryptocurrency as property for tax purposes, and not as cash or currency. The IRS intends to determine on a case-by-case basis whether an NFT constitutes a Section 408(m) collectible under the Code by analyzing whether the NFT’s associated right or asset is a Section 408(m) collectible, otherwise known as the "look-through analysis."
  • Requests public comment on any aspect of NFTs that might affect the treatment of an NFT as a Code Section 408(m) collectible.
According to Notice 2023-27, public comment must be submitted by June 19, 2023.

Tax Tip 2023-45: Digital Asset Reporting and Tax Requirements

On April 5, 2023, the IRS issued a tax tip to provide guidance to taxpayers on digital asset reporting and tax requirements for fiscal year 2022 tax filings. According to the tax tip:
  • All taxpayers filing 2022 tax year forms 1040 and 1040-SR must check a box indicating whether they received digital assets as a reward, award, or payment for property or services, or disposed of any digital asset that was held as a capital asset through a sale, exchange, or transfer.
  • If the "yes" box is checked on forms 1040 or 1040-SR, then taxpayers must report all income related to their digital asset transactions.
  • Examples of digital assets transactions include:
    • a sale of digital assets;
    • the receipt of digital assets as payment for goods or services provided;
    • the receipt or transfer of digital assets for free, without providing any consideration, that does not qualify as a bona fide gift;
    • the receipt of new digital assets as a result of mining and staking activities;
    • the receipt of new digital assets as a result of a hard fork;
    • an exchange of digital assets for property, goods, or services;
    • an exchange or trade of digital assets for another digital asset(s); and
    • any other disposition of a financial interest in digital assets.
The tax tip also provides guidance on which forms and schedules taxpayers can use to determine and report their capital gains or losses on digital assets.

Notice 2023-34: Convertible Virtual Currency as Taxable Property

On May 8, 2023, the IRS issued Notice 2023-34, which modified IRS Notice 2014-21 to clarify that convertible virtual currency is treated as property for federal tax purposes and that general tax principles applicable to property transactions apply to transactions using convertible virtual currency. Notice 2023-34 defines convertible virtual currency as virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency.
In addition, Notice 2023-34:
  • Revises a sentence in the "background" section of Notice 2014-21 to remove the statement that virtual currency does not have legal tender status in any jurisdiction.
  • States that virtual currency like bitcoin may serve one or more of the functions of "real" currency, but the use of virtual currency to perform "real" currency functions is limited.
According to Notice 2023-34, these changes were made because:
  • Certain foreign jurisdictions have enacted laws that characterize Bitcoin as legal tender since the issuance of Notice 2014-21.
  • The "background" section of Notice 2014-21 may be misinterpreted as overstating the similarity between convertible virtual currency and "real" currency because the use of convertible virtual currency, including Bitcoin, to perform "real" currency functions is limited.

Chief Counsel Advice Memorandum: Taxability of Cryptocurrency Protocol Changes

On April 21, 2023, the IRS Office of Chief Counsel issued a memorandum, dated March 27, 2023, to clarify whether certain cryptocurrency protocol changes constitute realization events under Treasury Regulation § 1.1001-1(a) (CCA 202316008). According to the memorandum, the IRS determined that an individual who holds cryptocurrency native to a distributed ledger does not realize gain or loss under IRC Section 1001 or income under IRC Section 61 when the ledger undergoes a protocol upgrade to change its consensus mechanism from proof-of-work to proof-of-stake (CCA 202316008). Under the facts of the IRS determination:
  • The units of cryptocurrency remain unchanged following the protocol change.
  • The individual continues to hold the same number of units of the cryptocurrency after the protocol change.
  • The individual does not receive any cash, services, or property (including additional units of the cryptocurrency) as a result of the protocol upgrade.