In the past few years, the digital asset industry has exploded both in growth and complexity. Just a few years ago, most digital asset holders would acquire a digital asset directly, anticipating it would appreciate. Now, with the growth of the digital asset derivatives market, such as futures, option products, and ETFs, a digital asset holder can invest in many more ways in this expanding industry. The ability to invest in a wide range of digital asset products brings several tax issues that must be considered.

This article is based on our joint presentation, “Updates on the Taxation of Digital Assets,” at the NYCPA Taxation of Financial Products Instruments Conference in January 2025.

Blockchain—the Engine Behind Digital Assets

To understand how to analyze the tax issues faced by the digital asset industry, we first need to have a working knowledge of the underlying technology called blockchain. Blockchain is simply a computerized, real-time general ledger of information shared and administered across a computer network called nodes (computer terminals). There is no central recordkeeper of the information. Blockchain technology is secure because changes can only be made to the information stored in the blockchain through a consensus protocol. Consensus can only be achieved if a majority of the nodes agree with the proposed modification to the block of information to be added to the chain. Accordingly, one would need to control most of the nodes in the network to corrupt the data. For example, if 100 people were in a private network sharing real-time data, the only way to manipulate the addition of data would be by establishing consensus. This means controlling at least 51 of the 100 computers nodes in the network. As a result, given the spread of the data on many nodes, manipulating information in a blockchain is exceedingly difficult, if not impossible.

At present, the two most popular consensus mechanisms are Proof of Work (PoW) and Proof of Stake (PoS). The first and most recognizable digital asset is Bitcoin, which relies on the PoW consensus model. To make a purchase with Bitcoin, the transaction first needs to be validated on the Bitcoin blockchain. In other words, the transaction will only be added as a new block of information on the chain after someone validates (approves) the transaction. These validators, referred to as miners, are required to solve a complex algorithm to validate the transaction. Once the algorithm is solved, the transaction is validated, and the validator is paid with a portion of the digital asset tracked in the blockchain (in this example with a portion of a Bitcoin). PoS validation modified the process by selecting its validators from only those potential validators that already own the specific digital asset related to that blockchain. Potential validators (referred to as stakers) will stake their digital assets for the chance to be selected as the validator of a transaction.

IRS Guidance and Frequently Asked Questions

The first guidance received from the government was IRS Notice 2014-21. The notice stated that virtual currency (the term used in the notice has since been replaced with the broader term digital assets) is property, not currency or any type of stock or security. The IRS also asserted that miners who are paid with digital assets for solving the algorithm must treat the fair market value of the digital asset received as ordinary compensation. After this first notice in 2014, the IRS issued Rev. Rul. 2019-24 along with a frequently asked questions (FAQ) section on the IRS website on how to treat certain types of unique transactions such as forks (when the blockchain is split into two and continues forward as two separate blockchains fueled by different digital assets) along with other clarification information. Since 2014, the IRS has updated the IRS FAQ section several times and has sporadically issued specific guidance addressing various transactions and their potential tax implications.[i][ii] Unfortunately, neither the IRS nor the U.S. Treasury has provided taxpayers and their tax advisors an overall approach to the taxation of digital assets and all of its potential transactions. All of the IRS guidance given thus far needs to be pieced together by taxpayers and their representatives.

Tax Issues

As digital assets are property, the tax analysis starts with Internal Revenue Code Section 1221 to determine if the digital asset is a capital asset or an ordinary asset in the hands of the taxpayer. This will depend upon the facts and circumstances of using the digital asset and the intent of the parties to the transaction. If a buyer is taxed as an investor, the digital asset is a capital asset and the digital asset investment should be treated as a capital asset generating capital gain or loss. As stated earlier, IRS Notice 2014-21 asserts if a miner is paid for services for validating a transaction to be added to a blockchain, then the fair market value of the digital asset received by the miner in payment is includible in gross income. This is most likely treated similarly to compensation for services. Rev. Rul. 2023-14, which dealt with staking rewards, added that such staking rewards are included in gross income for the year in which the taxpayer acquires dominion and control over the digital assets.

Although Notice 2024-21 suggests that mining and staking activity could be considered a trade or business, it does not conclusively state that all such activity qualifies as such. Some business activity may not rise to the level of a trade or business activity, but the risk that mining and staking could be deemed to be a trade or business could affect different taxpayers in different ways. Assuming mining/staking income is trade or business income, foreign investors could face the risk this income may be effectively connected income (ECI). Foreign investors would find their mining and staking activities conducted within the United States as U.S.-sourced income. In addition, such activity could also create a tax risk for U.S. tax-exempt investors because this same mining/staking activity would also generate unrelated business taxable income (UBTI). UBTI would result in taxable income to an otherwise tax-exempt entity. It is also asserted by some that if this income is not trade or business income, it could be considered as royalty payments or some other sort of fixed and determinable annual or periodic (FDAP) income that would require a 30 percent withholding on certain foreign investors. 

Assuming the digital asset is a capital asset, the taxpayer must evaluate the possible taxation of the digital asset against the existing tax rules that apply to all other types of financial investment products. For certain prominent and active digital assets (such as Bitcoin), the industry has  started to adopt the position these digital assets are commodities. However, most digital assets are still not treated as a stock or security but as property (following the IRS position). Accordingly, tax analysis as an investment asset can be challenging. For example, the wash sale rule outlined in Code Section 1091 addresses the deferral of a tax loss if a stock or security is sold for a loss and substantially identical stock or securities are purchased within 61 days surrounding the sale date. If the digital asset is not a stock or security, the wash sale rule of deferring the realized loss will not apply to digital assets. On the other hand, the straddle rules outlined in Code Section 1092 (a loss deferral rule) apply to  actively traded personal property, which includes some stocks and securities The rules apply when a taxpayer holds offsetting positions where the value of one position moves inversely to the other position. If the taxpayer sells the loss position, the tax loss is deferred while the taxpayer holds the offsetting appreciated property. Since the straddle rules apply to actively traded personal property, they may also apply to many digital asset transactions. A few years ago, Code Section 1092 would not have been a consideration for most digital assets because digital assets were not actively traded, and most digital asset holders would not have had the ability to enter into an offsetting position. With the growth of the derivative market, taxpayers can now own and hedge against the same digital asset, so the possible application of the straddle rules must now be considered by taxpayers and tax advisors.

Recent Reporting Issues

The IRS website tells taxpayers that the following transactions could potentially create a tax reporting obligation:

●  Receiving digital assets for any of the following reasons:

• Payment for property
• Payment for services
• A reward or award
• Mining, staking, airdrops, and similar activities
• As a result of a hard fork

●  The disposition, sale, exchange, or transfer ownership of digital assets:

• For another digital asset
• For U.S. dollars or another currency
• In exchange or trade for any amount of property, goods, or services
• Paying a transfer fee with digital assets
• Transferring ownership or a financial interest
• Being recorded as the owner of a digital asset
• Having an ownership stake in an account that holds one or more digital assets, including the rights and obligations to acquire a financial interest
• Owning a wallet that holds digital assets
  
  

In 2021, Congress expanded Code Section 6045 to include certain digital assets for purposes of sales and basis reporting. On June 28, 2024, the Treasury issued final broker reporting regulations. These regulations apply to sales of digital assets on or after Jan. 1, 2025. The regulations will require reporting of cost basis information on sales of covered digital assets and certain real estate transactions paid with digital assets. The regulations also outline certain penalty relief provisions. A draft of Form 1099-DA was issued by the IRS on Sept. 9, 2024, to disclose the sale and basis for digital assets conducted through a broker. This new form is scheduled to be due in 2026 for all calendar 2025 sales of digital assets. [1]

Changes to Cost Basis Reporting

Recently, the IRS issued Rev. Proc. 2024-28, which dramatically changed the cost basis tracking rules for digital assets. The IRS will no longer allow taxpayers to apply universal/multi-wallet cost allocations for digital assets. A wallet is  the common term used to indicate a platform or exchange used to store digital assets. Starting in 2025, the cost basis must now be calculated on a wallet-by-wallet/account-by-account basis. In other words, taxpayers cannot treat digital assets held in different wallets as if they were held in one giant wallet. Cost basis can no longer be allocated against a taxpayer’s entire digital asset portfolio. It now must be tracked and segregated separately by every wallet and every account. As this transition will be cumbersome, Rev. Proc. 2024-28 provides a limited safe harbor and allows taxpayers to rely on any reasonable allocation method of pushing the total cost basis back down to each digital asset in each wallet.

Although a taxpayer can use various accounting methods to calculate cost basis, they must notify their wallet exchange (broker) of the chosen method beforehand. If the broker is not notified by Jan. 1, 2025, the cost basis relief method will default to the first-in, first-out cost allocation method (FIFO).

Conclusion

As illustrated in this article, taxpayers must carefully analyze the tax treatment available to their digital asset transactions. As the popularity and complexity of digital assets grow, anyone who intends to use digital assets for business or investment purposes must take the time to understand the tax nuances, risks, and uncertainty that come with owning digital assets.

Navin Sethi, CPA, JD, LLM, is a senior tax partner at EisnerAmper Advisory Group as well as an adjunct professor at Golden Gate University in San Francisco, CA.