In the US, the IRS, the government agency responsible for collecting citizens’ taxes, is about to launch new software that will offer support to all those who need to track their crypto transactions in the DeFi world and need to calculate potential capital gains/losses.
This is a true tax reporting tool created specifically to allow Americans to file their taxes directly with the IRS without DeFi protocols having to file 1099 forms in connection with their clients’ activities.
In fact, a new bill proposed by the US Treasury Department would have required all decentralized exchanges to provide personal user data, just as they do with centralized brokers such as Coinbase.
The new software could save DeFi application developers from facing a law that has some absurdity given that there is no human counterpart but simply technology managing operations in this field.
The IRS And The New Software For Taxing Crypto In DeFi
The Internal Revenue Service (IRS), a US tax agency, is preparing to offer its citizens free software to support the reporting of taxes payable within the crypto DeFi world.
The move follows a “Direct File” pilot program that is expected to be rolled out in 13 states starting in 2024, and potentially holds all the cards to upend previous tax reporting rules.
Users of decentralized finance applications can simply take advantage of blockchain technology to track all transactions made with an overall recap of gains and losses that occurred within the calendar year.
This new software, similar to other existing services in the crypto tax context such as Token Tax, Koinly, and Zen Ledger, leverages public crypto databases to provide a comprehensive record of all transactions that have occurred in DeFi.
Users need only enter their address in a dedicated box, and the tool will return a reliable, complete, and detailed history of taxable transactions that occurred on protocols not managed by a central entity such as decentralized exchanges
This approach greatly simplifies a recent bill proposed by the IRS itself and the US Treasury Department that would require decentralized exchanges to provide a list of their customers’ personal information on so-called 1099 forms.
The main problem with this bill is that DeFi protocols are not operated by intermediaries and hence would have to totally change their approach to start recording personal customer data.
The IRS has also proven in the past that it is not an expert in keeping taxpayers’ private information secure: in 2016 the government agency was the victim of a hack in which it lost more than 700,000 Social Security numbers and other sensitive data.
In fact, security is not the workhorse of the IRS. which has been admonished several times by the Treasury’s Inspector General for Tax Administration precisely for its dastardly handling of data provided by taxpayers,
The tax reporting software in the DeFi niche, will eliminate this risk at the outset, as well as reduce the US Internal Revenue Service’s workload with the millions of 1099 forms that were expected to arrive under the new rule.
Once again, technology simplifies the difficulties caused by technology itself.
The “broker rule” and reporting requirements for DeFi platforms
The IRS’s decision to introduce the new tax-management software in DeFi to U.S. citizens comes only after a bill proposed in August that would have officially defined all decentralized services offering crypto exchange instruments as ” brokers.”
In a nutshell, all AMMs, self-custodial digital wallets with swap connections and decentralized trading protocols are considered the same as centralized services such as Coinbase, Binance, Kraken, Bitget, etc.
This framing would force DeFi services themselves to provide the IRS with a long list of information about their clients, as is the case with regulated brokers in the country who must report all on-boarding and off-boarding between crypto and US dollars conducted on their platforms.
This approach, although it can be agreed upon on a theoretical level given that it would greatly reduce the “tax gap” and tax evasion in the crypto field, cannot be applied from a practical point of view.
DeFi protocols are not businesses and do not have central intermediaries with a power to control what happens on these applications.
To think of forcing software to return detailed data of all clients conducting crypto transactions is totally insane, as it would set a precedent for the mandatory introduction of KYC verification.
Cryptocurrency exchange Coinbase had spoken out against this rule stating that no DeFi entity transacts digital assets within the authority granted by Congress, and hence should not be required to face such violence from authorities.
Furthermore, why should an imaginary intermediary be required to report tax information as if it were a broker?
This mess, created by the IRS itself with its recent bill, could be solved by the software mentioned in the previous paragraph.
On the one hand, it would eliminate the duty of decentralized counterparties to adjust to track their clients’ data and provide it secondarily to the IRS, with all the attendant risks of computer data theft.
On the other hand, this system would help the US IRS collect a decidedly non-underestimated amount of taxes in crypto given the growth the decentralized finance sector is experiencing.