Bitcoin, the world’s largest cryptocurrency, was first introduced in 2009. Since then, the cryptocurrency market has exploded: dozens of exchanges process billions of dollars in transactions each day, across thousands of different cryptocurrencies.

As we discussed in an earlier blog post, that trading volume translates to significant potential tax revenue. But the crypto market is an opaque and technically complex system, representing a new obstacle for tax authorities in the ongoing challenge of the shadow economy. 

At IVIX, we build technology that helps tax authorities gain visibility into the shadow economy. We recently published a new report that uncovers capital gains in crypto, leveraging publicly available data to reveal that US Bitcoin traders realized $30 billion in capital gains in 2021. 

In this blog post, we’ll discuss the challenges tax authorities face in collecting crypto tax revenue. 

Click here to download the full report: Crypto Capital Gains by US Persons

Which Crypto Events are Taxable?

Cryptocurrencies are considered a property, and may be subject to both income and capital gains taxes, depending on the event. In the US, income taxes arise when crypto is mined, received as salary, or airdropped. Capital gains taxes arise when cryptocurrency is exchanged either into another cryptocurrency or into fiat currency, or when payments are received for goods or services. 

There are multiple taxable events in an NFT sale. “Minting” (creating) an NFT is an income tax event, while selling an NFT can incur sales tax. An NFT resale can be subject to either capital gains or collectible capital gains. NFTs are purchased with crypto, and the payment is subject to capital gains on the cryptocurrency used. 

We found that 80-90% of the value of cryptocurrency received is received via trading on crypto exchanges, while only 2% of crypto transactions involve making purchases. 

Given this, we believe capital gains incurred by trading on exchanges and marketplaces offer the greatest return on investment in compliance. 

What Are the Challenges of Crypto Tax Compliance?

Tax authorities face two main challenges in driving compliance in crypto: reporting and accurately calculating cost basis. These challenges are mainly due to the use of unregulated exchanges. 

Regulated and Unregulated Exchanges

Exchanges allow investors to exchange cryptocurrencies for traditional currencies. They are similar to stock exchanges, but are not currently regulated by the SEC. 

Exchanges that are connected to the banking system are either based in the US or comply with US regulation (or strictly forbid US persons from using them, such as Bitfinex). Such exchanges include Binance, Coinbase, Kraken, Bitstamp, Poloniex, Bittrex, and Gemini. 

Overseas exchanges that work around the banking system generally do so by using stablecoins as the store of value and allowing only cryptocurrency deposits. To use these exchanges, you have to convert fiat currency to crypto on an exchange connected to the banking system, then transfer the crypto to the overseas exchange. These exchanges are regulated poorly, if at all, and though some mention that US persons are not permitted to sign up, they rarely enforce this rule. 

A new and quickly growing concept in crypto is decentralized finance, or DeFi. By design, decentralized exchanges are not controlled by a single entity acting as a custodian of the funds, which makes regulation such as high-volume transaction reporting or KYC harder — but not impossible.

Reporting Challenges

As money service businesses (MSBs), US-regulated exchanges and ATMs are subject to Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements, which means they must collect particular information about their users. These requirements don’t currently include crypto wallets. 

The recently passed HR 3684, the Infrastructure Investment and Jobs Act, introduces two new reporting requirements for crypto market participants aimed specifically at improving tax compliance: 

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• A requirement for so-called “digital brokers” to issue 1099-B forms for their customers. This covers crypto exchanges and ATMs, but may also cover entities like wallet apps. 
• A requirement that extends Section 6050I of the US tax code, requiring recipients of transactions over $10,000 to report certain information about the person from whom the payment was received. 

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Both of these provisions have drawn criticism from industry for a perceived lack of clarity and feasibility.

We believe that these provisions will have a significant positive effect on tax compliance, because they ensure that crypto capital gains and major transactions will be reported to the IRS. However, they don’t fully solve the challenge of calculating capital gains that run through unregulated exchanges. 

Cost Basis Calculation Challenges

As discussed above (see Exchanges), for a US person to trade on an unregulated exchange, they must start on a US-regulated exchange. They must also bring their crypto back into a regulated exchange to cash out. Calculating the cost basis for such a transaction is very difficult for a regulated exchange.

In this situation, Coinbase has no way to accurately calculate the cost basis for a 1099-B since they have no insight into activity on the unregulated exchange. 

Transform Metaverse Compliance with IVIX

This post described the challenges that tax authorities face in promoting compliance in crypto. In our next post, we’ll share potential solutions. 

Crypto is becoming increasingly mainstream as NFTs and the metaverse grow rapidly. Tax authorities around the world are using IVIX to ensure that NFT traders and metaverse businesses comply with the tax code. To learn how our platform can help you, click here to book a demo.