Crypto Self-Custody Protects Sensitive Data From Tax Authorities

The collapse of major crypto firms last year awakened investors to the harsh reality of crypto custody. Not only did customers lose access to their crypto on exchanges when they failed, but US investors also became responsible for complying with tax laws overseen by the Internal Revenue Service (IRS) even though they didn’t own keys to their crypto.

Just a few weeks ago, the United States Treasury Department proposed new laws for catching crypto tax cheats and making it easier for obedient citizens to file returns. 

Under the draft tax laws, crypto exchanges must report gross transaction proceeds. Later, they would need to report the cost basis or how much customers paid for assets they later sold.

The difference between the investor’s cost basis and the price they sold the assets for would constitute taxable income.

Despite their best efforts, investors keeping crypto in non-custodial wallets have historically faced nightmares trying to track gains that span multiple decentralized finance (DeFi) applications. The fact that service providers help track transactions is not always useful since different providers can present wildly different results, says tax expert Clinton Donnelly.

US Crypto Investors Can Use Self-Custody Until New Tax Laws Are Effected

But US DeFi investors are safe from the tax man for now. The government only plans to start taxing decentralized finance profits in a few years.

Despite the grace period, it is important to start balancing the need for disclosures with the privacy crypto enthusiasts crave. This is according to the CEO and co-founder of tax firm Recap, Dan Howitt.

In addition, it is critical to educate users on setting up their crypto self-custody, which, for the most part, has proven too daunting, pushing investors to surrender autonomy in service of usability. Keeping track of gains and losses can also take a lot of work.

But, self-custody is the only way to preserve crypto’s goals of censorship-resistance and guard against future collapses, according to Howitt. With more education, self-custody can help customers obey crypto tax laws without revealing sensitive information.

Read our step-by-step guide on how to set up and manage your own crypto wallet.

But first, a primer on why DeFi transactions are so hard to track.

Only Code Knows Your Identity

A core feature of decentralized finance is the ability to transact without intermediaries. Hayden Adams, the developer of decentralized exchange (DEX) Uniswap, and Michael Egorov, the creator of stablecoin DEX Curve Finance, allow crypto investors to make their own markets for exchanging crypto assets.

In other words, these platforms deploy special code that allows users to exchange crypto assets peer-to-peer. They create markets largely independent of rules imposed by regulators like the US Securities and Exchange Commission (SEC), although this could change.

Interested in creating your own markets? Read our primer on decentralized exchanges here.

Until the recent crypto collapses, Uncle Sam was content to let DeFi enthusiasts amuse themselves. Unrestricted, investors could experiment with products whose yields dwarfed returns banks pay savers.

A keystone feature of this type of investing is pseudonymity. Most decentralized platforms only need investors to connect software that allows them to spend assets using a private key divorced from personally identifiable information.

Read about the decentralized finance revolution here.

Sometimes, DeFi investors are exposed when their wallet addresses are linked with their profiles on other platforms like X (formerly Twitter). While their real identities are still mostly safe from prying eyes, it often takes stolen data from a platform like X to link an address to a real-world entity.

The pseudonymity of crypto transactions has given regulators sleepless nights. Last year, the US sanctioned Tornado Cash, a decentralized application that obscures the identity of depositors. Later, US tax authorities partnered with an artificial intelligence firm to track tax fraud on blockchains.

Regulators Could Force Data Collection for Crypto Tax Defaults

Danny Chong, the CEO of Tranchess, a DeFi yield platform, recently told BeInCrypto that DeFi needs regulations to shape its future. But is the surrender of private information the price we have to pay?

The proposed US Crypto-Asset National Security Enhancement Act of 2023 requires parties who control or otherwise have invested in a DeFi protocol to collect customer information.  It would also give the Treasury additional powers to prosecute money laundering conducted outside the traditional financial system.

International anti-money laundering bodies like the Financial Action Task Force (FATF) recommend anti-money laundering rules that European Union regulators saw fit to include in their crypto legislation, the Markets in Crypto-Assets (MiCA) bill. Due to become effective in 2024, MiCA asks exchanges to record parties at both transaction ends, irrespective of the amount exchanged.

So, things look pretty bleak on the anonymity front. Or maybe not. Howitt thinks the way forward is not as cut-and-dried as we may think.

“Everyone has a right to financial privacy. If data gets in the wrong hands, your portfolio could be exposed, opening up the potential for you to paint a target on your back,” he said.

Recap’s services preserve crypto anonymity or, in a stricter sense, pseudonymity while allowing investors to fulfill tax obligations. Moreover, he doesn’t see blockchains advocating privacy at the expense of crime.

“As soon as one transaction is exposed, everything is exposed,” he added.

Howitt said that rules, for example, those outlined in the Organization for Economic Co-operation and Development Crypto-Asset Reporting Framework, could push people towards offshore venues that risk their funds. If more investors chose to self-custody, it would have limited the damage they sustained by handing over their assets to companies that recently failed.

Recap Tracks Crypto Tax Gains With Self-Custody

It’s time to change the conversation, Howitt argues:

“We’re used to banks and fintech companies managing our finances, and the days of us having full control of our money are long gone. Self custody gives you absolute control of your funds, and no third party will have access… We’ve become so used to banks doing this for us.”

Instead of allowing the government to link centralized exchange wallets with DeFi investors and reveal all their DeFi trades, Recap tracks all transactions through its tight integration with Ethereum. By far the largest DeFi blockchain, Ethereum is home to established services like Uniswap, Curve, and liquid staking protocol Lido.

Recap’s Success May Depend on Wallet Providers

But until MiCA and other laws come into effect, it is uncertain how popular the service will be. From a technical standpoint, Recap could theoretically be affected by changes to the Ethereum blockchain.

Upgrades to Ethereum transaction blocks will accommodate cheaper transaction blocks. In the interim, several zero-knowledge projects will improve the scalability of Ethereum. Self-custodial wallet providers like MetaMask and Ledger have also experienced hacks and have been accused of undermining the ethos of crypto.

Learn how to safeguard crypto in non-custodial wallets here.

Moreover, it remains to be seen whether companies like Recap would need to change their approach when new US laws come into effect. In September last year, the IRS issued a John Doe summons to New York-based M.Y. Safra Bank clients who may have failed to pay taxes on crypto transactions.

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