How The New (Proposed) IRS Crypto Tax Rules Will Impact DeFi

New proposed tax changes have the potential to shake up the DeFi space for U.S. investors.

The U.S. has achieved a (unfortunately accurate) reputation as a legal and regulatory landscape that is not particularly open and receptive to cryptoassets and crypto innovation. Antagonistic relationships have taken the form of lawsuits, lack of authoritative reporting and accounting standards, and a general stand-offish position toward the sector. Tax authorities are no exception to this rule, and the IRS has made no secret of the fact that it is actively pursuing tax revenues connected to cryptoassets and crypto transactions. Since 2019 the IRS has sent out thousands of letters to taxpayers, with varying levels of forcefulness, requesting that taxes associated with the crypto sector be paid. These actions are in addition to the multiple requests and legal actions taken against centralized U.S. exchanges such as Coinbase, Kraken, Binance U.S., and others.

It is also worth noting that even though the current debate and conversation around proposed crypto tax reporting changes began in August 2023, the issue itself was actually introduced back in 2021 with the Bipartisan Infrastructure Plan. In August 2023, however, the Biden Administration released a new proposed tax framework that would implement these proposed rule changes into a reality, with major changes centering around 1) which entities would qualify as a broker going forward, and 2) what the reporting requirements of these brokers would be. Specifics that distinguish this proposed rule from other iterations are that this rule mentions and includes NFTs, requires a new tax document (1099-DA), specifies which entities will now be considered brokers (including decentralized service providers), and changes reporting requirements for transactions over $10,000. While public comment and feedback periods yet remain, the rule is scheduled to be effective in 2025 for the 2026 tax season.

That is a lot of potential changes impacting large swaths of the crypto sector, so let’s take a look and some items investors should watch as this rule moves forward.

DeFi Is On The Hot Seat

One of the most controversial aspects of this proposed rule is the expanded classification as to which entities are considered brokers. Since the idea was first introduced there has been pushback from the industry, including lobbying groups, to limit the expansion of this definition, as well as the obligations that would be placed on these entities. Since 2021 the crypto sector has not improved its reputation, at least in the eye of some policymakers and regulators, and DeFi is a prime example of this. Decentralized exchanges (DEXs) strike many in the TradFi space as inherently risky and prone to fraudulent activity, even with the dismissal of a class action lawsuit against UniswapUNI

One of the biggest changes in this proposed rule is that DEXs will fall under the broker umbrella, necessitating a wholesale re-thinking of not only DEX operations, but re-evaluating the risk for U.S. investors that have any funds pass through these entities.

Audits And Collections Will Rise

The IRS has already publicly stated that audit levels will be returning to historic rates for some taxpayers versus the lower rates that have been commonplace over the last several years. When combined with the estimates that taxes on crypto are proposed to bring in ($28 billion according to most estimates), it stands to reason that the frequency of audits for crypto investors and entrepreneurs is set to rise. Additionally, with the increased prioritization that the IRS has placed on crypto transactions and taxes, most notably in prioritizing data collection via Form 1040, the picture becomes clear; audits and expected revenues generated from crypto investors will only increase moving forward.

Framed in the context of seeking new revenue streams, the expansion of the broker classification, and the increasing amount of compliance and reporting set to be expected of these organizations also has tax collection benefit; better and more comprehensive audit trails.

Crypto Continues To Be Legitimized

Although the proposed rules changes have faced pushback from the industry virtually from the minute they were introduced, the reality is that these conversations and potential changes continue to legitimize the sector at large. Put simply, if the IRS is estimating that $28 billion in tax revenue will be generated from an economic area, those activities look less likely to be banned or otherwise rendered impossible to conduct. As some of the largest TradFi institutions invest in crypto, accounting firms and software providers incorporate crypto into product offerings, and nation-states embrace tokenization, it is evident that crypto is here to stay.

It is a positive development that crypto is increasingly viewed and treated as a legitimate asset class, which is undoubtedly positive long-term, but this also brings challenges for investors and entrepreneurs. Specifically as larger institutions are drawn to the space, there will be increasing expectations around transparency, compliance, and real-time attestation practices in the space.

Crypto tax changes might not be popular in many corners, but are a true sign of the continued growth and maturation of the sector.

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