The United States Internal Revenue Service (IRS) has issued a temporary relief for a rule that would have defaulted crypto holders on centralized exchanges to a less-than-ideal accounting method. This change provides some much-needed breathing room for investors, who can now maintain their preferred accounting method until December 31, 2025.
Background on the Initial IRS Rulings
The initial IRS rulings stated that if investors holding crypto assets with a Centralized Finance (CeFi) broker didn’t select their preferred accounting method, like Highest In, First Out (HIFO) or Spec ID, the broker would default to reporting sales using the FIFO method. This move sparked concerns among crypto enthusiasts and experts, who warned of its potential consequences.
Understanding FIFO: A Default Accounting Method
FIFO, otherwise known as ‘First In, First Out,’ is the default method for calculating capital gains tax in the US. It’s calculated by assuming the oldest cryptocurrency bought is sold first, pushing up a taxpayer’s capital gains. This method can be detrimental to crypto investors, especially during a bull market.
The Consequences of Defaulting to FIFO
Imposing this rule immediately could have been disastrous for many crypto taxpayers, according to Shehan Chandrasekera, head of tax at Cointracker. He warned that investors might unintentionally sell their earliest purchased assets — those with the lowest cost basis — first, thereby unknowingly maximizing their capital gains.
The Risks of FIFO: A Crypto Tax Perspective
Mark Thomas, a crypto commentator, weighed in on the potential consequences of defaulting to FIFO. He noted that while FIFO can be beneficial in certain situations, it’s not always the best choice for crypto investors. ‘The one time that FIFO can be good is if your sale date is more than one year after the earliest crypto you bought, but less than one year after the latest crypto you bought,’ Thomas said.
Long-term Capital Gains vs. Short-term
Thomas also pointed out that FIFO can result in long-term capital gains instead of short-term, which can have significant tax implications for investors. ‘FIFO, in this case, would mean long-term capital gains instead of short-term,’ he explained.
Temporary Relief: What It Means for Crypto Taxpayers
The temporary relief applies to sales on centralized crypto exchanges until December 31, 2025. During this time, brokers will be required to support all accounting methods, allowing taxpayers to maintain their own records and choose their preferred method.
Blockchain Association Takes Legal Action against IRS
This update comes just days after the Blockchain Association and the Texas Blockchain Council filed a lawsuit against the IRS on December 28. The lawsuit argues that the rules requiring brokers to report digital asset transactions and expanding existing requirements to include platforms like decentralized exchanges (DEXs) are unconstitutional.
What’s at Stake: Tax Implications of Defaulting to FIFO
Once the rules take effect in 2027, brokers must disclose information about taxpayers involved in digital asset transactions. They must also report their gross proceeds from crypto and other digital asset sales. This can have significant tax implications for investors, making it crucial for them to understand the rules and choose the best accounting method.
A Bull Market Concern: Unintentional Capital Gains
The initial IRS ruling sparked concerns among experts and investors about the potential consequences of defaulting to FIFO during a bull market. Investors who unintentionally sell their earliest purchased assets first can unknowingly maximize their capital gains, leading to unexpected tax liabilities.
Conclusion
The temporary relief provided by the IRS is a welcome reprieve for crypto holders on centralized exchanges. While it’s essential for investors to maintain accurate records and choose their preferred accounting method, this update offers some much-needed breathing room until December 31, 2025. As the rules regarding digital asset transactions continue to evolve, it’s crucial for taxpayers to stay informed and adapt to any changes.
Sources:
- Shehan Chandrasekera, head of tax at Cointracker
- Mark Thomas, crypto commentator
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