Crypto Self-Custody: Protecting Sensitive Data from Tax Authorities

The collapse of major crypto companies last year brought attention to the importance of crypto custody. It highlighted not only the loss of access to crypto assets on exchanges but also the responsibility for tax compliance faced by US investors who didn’t hold the keys to their crypto.

In response to this, the United States Treasury Department has proposed new tax laws that aim to catch crypto tax evaders and facilitate easier tax return filing for law-abiding citizens. Under these proposed laws, crypto exchanges would be required to report gross transaction proceeds and later report the cost basis of assets sold by customers.

Investors who store their crypto in non-custodial wallets have historically faced challenges when it comes to tracking gains across multiple decentralized finance (DeFi) applications. The assistance of service providers in tracking transactions has not always been reliable, as different providers can produce differing results, according to tax expert Clinton Donnelly.

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

For the time being, US DeFi investors are safe from taxation. The government plans to start taxing DeFi profits only in a few years. However, it is still important for investors to balance their need for privacy with the need for disclosure. Dan Howitt, CEO and co-founder of tax firm Recap, emphasizes the importance of educating users on setting up their own crypto self-custody, which has proven to be challenging for many investors.

Despite the difficulties, self-custody is seen as the only way to preserve the principles of crypto, such as censorship-resistance and protection against future collapses, according to Howitt. With proper education, self-custody can help customers comply with tax laws without compromising sensitive information.

Only Code Knows Your Identity

In decentralized finance, the ability to transact without intermediaries is a core feature. Platforms like Uniswap and Curve Finance enable users to exchange crypto assets peer-to-peer through special code. These platforms operate largely independently of regulatory rules imposed by entities like the US Securities and Exchange Commission (SEC).

Although the US government previously allowed DeFi enthusiasts to experiment freely, the pseudonymous nature of decentralized platforms has raised concerns for regulators. They worry that this anonymity may facilitate criminal activities. Some actions have been taken to address this, such as the sanctioning of decentralized applications that obscure depositor identities and the partnership between US tax authorities and an artificial intelligence firm to track tax fraud on blockchains.

Regulators Could Force Data Collection for Crypto Tax Defaults

According to Danny Chong, the CEO of Tranchess, regulations are necessary for the future of DeFi. However, the question remains: is surrendering private information the price that must be paid?

Proposed acts like the US Crypto-Asset National Security Enhancement Act of 2023 require parties involved in DeFi protocols to collect customer information. Similarly, the Markets in Crypto-Assets (MiCA) bill, which will be effective in the European Union in 2024, asks exchanges to record information about the parties involved in transactions.

While the future of anonymity in crypto transactions seems uncertain, Howitt believes that privacy rules should not lead to criminal activities. He thinks that advocating for privacy protections is a way to prevent exposing transaction information, which can potentially put investors at risk. Howitt also emphasizes that self-custody can limit the damage caused by asset losses due to company failures.

Recap Tracks Crypto Tax Gains With Self-Custody

To ensure privacy and fulfill tax obligations, Recap, a tax firm, tracks all transactions through its integration with Ethereum. Ethereum is the largest blockchain network in decentralized finance, hosting popular services like Uniswap, Curve, and Lido.

However, the success of services like Recap may be dependent on wallet providers. Changes to the Ethereum blockchain and potential upgrades could impact the functionality of such services. Additionally, the introduction of new US laws could require companies like Recap to adjust their approach.

Ultimately, self-custody provides individuals with full control over their funds and allows them to maintain their financial privacy. It’s important to stay informed about developments in self-custody and its implications for tax compliance.

Opinion by [Your Name], Crypto Expert

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