Taxpayers Have Until January 1, 2025, to Make Use of Safe Harbor Digital Asset Basis Allocation

On June 28, 2024, the IRS released a package of guidance related to the broker reporting rules created by the Infrastructure Investment and Jobs Act. One of these regulations addresses the manner in which taxpayers should determine basis for digital assets, which is different from how many taxpayers may have been determining and allocating basis previously. While significant attention has been paid to the final regulations relating to the new broker-dealer requirements, the IRS also released a notice allowing a safe harbor for those taxpayers who may have unused basis to allocate basis in digital assets to wallets or accounts. Taxpayers need to act quickly to evaluate and allocate any unused basis, as the allocations must generally be made by January 1, 2025. 

Tax Treatment of Digital Assets 

In 2014, the IRS advised that digital assets are treated as property for federal income tax purposes in Notice 2014-21. This means that the same methods of tracking basis to determine gain or loss apply to digital assets the same as other property. The IRS issued further guidance in 2019 in the form of frequently asked questions, which included guidance on determining basis in digital assets that were purchased, received in exchange for other property or service, or received as gifts. Many taxpayers understood this guidance to permit the use of a universal method for tracking basis in digital assets across wallets or accounts. The universal method treats all of the taxpayer’s digital assets as if they were held in the same wallet or account, even if they were not.  

To illustrate, consider the following example: 

A taxpayer holds thirty units of cryptocurrency. Ten are held at a cryptocurrency exchange (“Wallet A”), and twenty are held in a non-custodial hardware wallet (“Wallet B”). The taxpayer bought ten units at $1/unit in 2019 (for $10 total), which are currently held in Wallet A. The taxpayer later bought twenty units at $5/unit in 2020 (for $100 total), which are currently held in Wallet B. The taxpayer’s total basis would be $110. 

If the taxpayer later sold six units held in Wallet A for $100, they may have assumed a cost basis of $30 using a universal “highest-in, first-out" (“HIFO”) approach, for a gain of $70, and a remaining unused basis of $80. Alternatively, if the taxpayer had used the account-by-account approach, they would have used a basis of $6 for the sale, for a gain of $94, and remaining unused basis of $104. Either way, the taxpayer would have twenty-four units of cryptocurrency left, with twenty units of unused basis (from two tax lots).  

Final Regulations 

The final broker regulations released on June 28, 2024, set forth how taxpayers must determine basis going forward under Treas. Reg. 1.1012-1(j), which deals with the “sale, disposition, or transfer of digital assets.” (For purposes of this article, “sale” and “sold” encompass sale, disposition, or transfer.) Under this regulation, digital assets are treated slightly differently depending on whether they are held in the custody of a broker or not. 

Starting on January 1, 2025, for digital assets not held in the custody of broker, such as decentralized wallets or accounts, the basis and holding period of units sold is determined either by making specific identification of the units sold or by using the “first-in, first-out” (“FIFO”) methodology. Specific identification is made if the taxpayer identifies on its books and records the particular units to be sold referencing any identifier sufficient to identify the units sold no later than the date and time of the sale.  

The same is generally true for digital assets held in the custody of broker, however, for these taxpayers must make adequate identification of the units sold to avoid the use of FIFO. Adequate identification occurs if the taxpayer specifies to the custodial broker the particular units to be sold by no later than the date and time of the sale. The taxpayer may reference any identifier that the broker designates as being sufficient to identify the units sold.  

Transition Relief and Safe Harbor  

Rev. Proc. 2024-28 grants relief to taxpayers who historically used the universal method as they transition to the requirements under Treas. Reg. Sec. 1.1012-1(j). Taxpayers may elect to use a safe harbor under Rev. Proc. 2024-28 to make a reasonable allocation of digital asset units of unused basis to a wallet, provided that:  

1. The digital asset unit is a capital asset in the hands of the taxpayer (note: taxpayers may need to discuss with a tax professional to determine if they meet this criteria);  
2. Each unit of unused basis was originally attached to a digital asset unit that was a capital asset in the hands of the taxpayer;  
3. The digital asset unit from which the unused basis is derived and the remaining digital asset unit are the same type of digital asset (meaning a taxpayer can not allocate basis from Bitcoin to Ether or vice versa); 
4. The taxpayer can identify and maintain records sufficient to show the number of units of unused basis, the original cost basis of each unit of unused basis, and the acquisition date of the digital assets to which the unused basis was originally attached; and 
5. The taxpayer treats any allocation under the safe harbor as irrevocable.  

This allocation must be done account-by-account.  

The safe harbor allows two methods of allocation: specific unit allocation and global allocation. (The basis method should not be confused with a method of accounting. You may use a different method for each wallet without triggering a requirement to file Form 3115, Change in Accounting Method.) Global allocation is an approach whereby the taxpayer documents how they will allocate unused basis to their holdings. Specific unit allocation is done by allocating units of unused basis that are specifically identified to either a pool or specific units of remaining digital assets within the wallet.  

Global allocation must be done by January 1, 2025, while specific identification allocation must be completed by the earlier of: 

1. The date and time of the first sale, disposition, or transfer of the same type of digital asset, completed on or after January 1, 2025; or 
2. The due date (including extensions) of the taxpayer’s federal income tax return for tax year 2025. If the taxpayer is not required to file a 2025 federal income tax return, it must be completed by the due date (including extensions) of the type of return they would otherwise be required to file for 2025.  

Returning to the above example, the taxpayer was left with twenty-four units of cryptocurrency and twenty-four units of unused basis. Assuming the taxpayer used a universal basis HIFO approach, they would have $80 in basis remaining (ten units at $1/unit and fourteen units at $5/unit) that needs to be allocated to four units held in Wallet A and twenty units held in Wallet B. The taxpayer may allocate this unused basis based on a consistent rule or by specifically allocating basis to specific units. For instance, the taxpayer could swap the basis from Wallet A to Wallet B or specifically allocate the lots for each wallet. While a taxpayer could take no action, if they previously used a universal method of accounting, they will not be protected under the safe harbor if their return is selected for examination.  

Based on the example above, if the taxpayer would prefer to recognize a lower capital gain as the result of the digital asset sale, they could specifically allocate the highest basis to the tokens anticipated to be sold next. 

This change to basis allocation is just one part of broader changes to how digital asset sales and dispositions are tracked and reported. For some, this safe harbor may present an opportunity to allocate basis in a way that is overall more favorable, but they must act soon. Taxpayers who are impacted by these changes should consult with a trusted tax advisor to stay current on their compliance obligations.