A universal wallet in the digital age
Earlier this summer, the IRS released final regulations on gross proceeds and basis reporting by digital asset brokers. (T.D. 10000) In addition to third party reporting, the final regulations introduce significant changes to how digital asset transactions must be reported and tracked for tax purposes. Taxpayers no longer will be able to track the basis of their digital assets as if they were held in a single account or address (sometimes referred to as the “universal wallet approach”).
The new regulations present practical challenges for taxpayers who track basis in assets held amongst multiple brokers and in self-custody addresses. In the digital ecosystem, it’s common to use multiple addresses because the risk of total loss is reduced if one address is compromised. Indeed, a single digital wallet can use multiple addresses. Multiple addresses also facilitate financial reporting by taxpayers because they can help segregate transactions by type, and automated rules can be established in tax software to categorize transactions for specific wallets. To mitigate the challenges caused by eliminating the universal wallet approach to tracking assets, the IRS also released Rev. Proc. 2024-28. The goal of the revenue procedure is to ease tax reporting going forward by allowing taxpayers to reallocate basis in their remaining digital asset holdings as of Jan. 1, 2025.
Because digital assets are treated as property, every disposition of a digital asset requires consideration of whether a gain or loss has been realized. With digital asset tax software, tracking basis and calculating gain or loss has become routine. This is true even for taxpayers holding thousands of digital assets across multiple addresses or exchanges. In many cases, taxpayers only provide the software with the addresses of their digital wallets. The software will import or read the address activity and compute gain or loss for a year. With fungible property such as shares of stock or units of inventory, taxpayers have options when identifying the asset being sold so that the appropriate basis is used for computing gain or loss. These same options are available in digital asset tax software, where taxpayers can identify the asset or assets being transferred in a variety of ways FIFO, highest-in, first-out (HIFO) and specific identification.
Digital wallets don’t hold identifiable assets themselves but rather store the public and private keys that allow the owner to write valid transaction messages on a blockchain. Digital assets are, in reality, “data” or “ledger entries” within the blockchain specifying which wallet address has the right to initiate a transaction and transfer assets between addresses. Because digital assets are like “ledger entries,” to determine the basis of the digital asset being sold or transferred, tracking software must incorporate information about when the asset was received (the earlier “ledger entry”). Early IRS guidance recognized that taxpayers must match a sale (send) transaction with an earlier buy (receive) transaction to identify a specific unit of virtual currency or even apply the FIFO rule. Q&A 40. That early guidance was silent on when the transaction matching needed to take place or who had to be in custody of the digital asset at the time of the sale. In a virtual world, that silence didn’t matter. A computer program can easily combine activity across multiple addresses and match sales with buys, which was referred to as the “universal wallet approach.”
The new regulations introduce significant operational challenges for the digital asset industry, which has relied heavily on the flexibility of multiple self-custody addresses for managing assets. Taxpayers use various addresses to segregate different types of assets and transactions, such as having an address on a laptop for regular transactions, a mobile address for on-the-go access, and a highly secure cold storage address for long-term holdings. However, the requirement to allocate basis and track transactions on an address-by-address basis disrupts this well-established practice, complicating asset management and reporting in several ways. Taxpayers must now track the basis and transaction history for each individual address, creating a significant administrative burden as they need to ensure accurate and consistent data across multiple addresses when executing transactions. Managing multiple addresses with different levels of security and accessibility, which was previously streamlined, now necessitates additional steps to reconcile and report transactions separately for each address, leading to potential operational delays and increased chances of error. Furthermore, current digital asset tax software may not be equipped to handle the granular tracking required by the new regulations, requiring either significant upgrades to existing systems or the adoption of new software solutions, both of which can be costly and time-consuming.
Custody now matters
The release of the final reporting regulations and the companion Rev. Proc. 2024-28 make it clear that taxpayers cannot identify digital assets being sold or transferred under the rubric that they are held in one account. Taxpayers not adopting the default FIFO rule for every account, must now identify the digital asset being sold no later than the date and time of the sale. Without specific identification prior to or at the time of sale, brokers must apply the FIFO rule to track basis on the digital assets held in the taxpayer’s account. Taxpayers in custody of their assets can adopt a standing rule in their books and records that specifically identifies a unit selected by a self-custody address for disposition, if the rule sufficiently established which unit was removed from the address. Applying these rules may be challenging for digital asset tax software, especially without continuous access to the user’s wallet.
Transitional relief to allocate unused basis amongst remaining assets
Under the universal account approach, the basis of units held by Broker A could have been allocated to the units sold by Broker B (or in a self-custody wallet). Terminating the universal account approach without providing transitional relief, would leave overstated bases in Broker A’s records and understated basis in Broker B’s or the taxpayer’s records. Rev. Proc. 2024-28 allows taxpayers to make any reasonable reallocation of unused basis to digital assets held within each wallet or account of the taxpayer as of Jan. 1, 2025.
What should taxpayers consider
Given the requirement to track the basis and transaction history for each individual digital asset account, taxpayers should review their current account structures and usage patterns to identify areas where more granular tracking and reporting might be necessary. To ensure compliance, taxpayers should consider developing clear, internally documented standing rules that align their business practices with the regulatory requirements. These rules should cover processes for documenting address activity, categorizing transactions and tracking basis for each account.
Currently, many individuals and companies use digital asset tax software or maintain a comprehensive list of cost basis themselves for all their digital assets, irrespective of the account in which they are held. When a sale is made, they may select a specific asset from this list based on their financial strategy, such as choosing a high-cost basis asset to generate the lowest gain. However, under the new regulations, taxpayers must ensure that the basis is allocated by account. This means that the cost basis for assets must be tracked and identified within the specific account from which they are sold.
Taxpayers will need to assess whether their existing digital asset tax reporting process can handle the new wallet-level tracking and be prepared to make any necessary changes or adopt new systems. Beyond evaluating the technical capabilities of these solutions, it’s crucial to assess the potential impact on operational agility. Adapting to these new requirements may necessitate changes in how organizations can process transactions, manage records, and respond to regulatory demands.
Our tax professionals at RSM US are here to guide you through the IRS’s final regulations on gross proceeds and basis reporting for digital assets. We’ll help ensure your practices align with these new requirements and provide expert guidance on any necessary adjustments.
