Are Foreign Digital Assets Held in Custodial Wallets Reportable?

Are Foreign Digital Assets Held in Custodial Wallets Reportable?

Are Foreign Digital Assets Held in Custodial Wallets Reportable?

When it comes to digital assets such as cryptocurrency, there are various ways in which a person may hold their cryptocurrency. Two of the main ways a person may hold their cryptocurrency is in a custodial wallet or a non-custodial wallet. These two types of mechanisms are entirely different — and will have different international reporting requirements to the IRS. With a custodial wallet, it means that a third party has control over the account. While it may not be considered an account per se — in the traditional way that a bank account is established – the concept is the same. One example of a custodial wallet would be Binance. Another version of a wallet to hold virtual and other currency is a non-custodial wallet, such as an individual’s flash drive in which they are the only people (or people that they designate) who have access to the keys. Let’s go through four common examples.

Digital Asset Custodial Wallet

A custodial wallet is very common — especially for newer investors of digital assets. For example, a person may acquire cryptocurrency and then maintain their cryptocurrency on an exchange such as Binance. While the person may have a separate identifier for the cryptocurrency, Binance has control over the entire exchange and therefore would have access to the account. There are pros and cons to this approach but since cryptocurrency is DeFi (Decentralized Finance), Taxpayers must be very careful so as to not end up in a situation such as Quadrigacx. From a reporting standpoint, at the present time, the IRS does not require accounts that solely hold cryptocurrency to be reported on the FBAR – but they may be required for FATCA Form 8938. In addition, there are current regulations being considered to require reporting similar to a foreign account.

Hybrid Digital Asset/Fiat (Custodial)

If a custodial wallet contains both cryptocurrency and other types of Fiat then the situation is different. In that type of scenario, the IRS has indicated that the taxpayer must report the account in the mirror fact that it might be phrased as a custodial wallet as opposed to an account would not necessarily negate the requirement. That means that if the taxpayer has both virtual or cryptocurrency along with dollars or euros in a foreign exchange wallet, then it would be reported on the FBAR (and presumably Form 8938 as well).

As provided in the (2022) IRS Publication 5569:

      • Example: A foreign account holding virtual currency is not reportable on the FBAR (unless it’s a reportable account under 31 C.F.R. 1010.350 because it holds reportable assets besides virtual currency).

      • These funds aren’t reportable at this time, per FBAR regulations issued by FinCEN February 24, 2011, but FinCEN Notice 2020-2 indicates FinCEN’s intention to propose amending the regulations to include virtual currency as a type of reportable account under 31 CFR 1010.350.

Non-Custodial Digital Asset Wallets

Noncustodial wallets are not foreign financial institutions and therefore typically there would not be any FBAR reporting required (Form 8938 has some ambiguity as to reporting). For example, if a taxpayer has their own overseas cryptocurrency maintained on their own personal wallet, then that is generally not required to be reported on the FBAR.

Non-Custodial Digital Assets Placed in a Lockbox

A situation that could get a bit dicey is if the taxpayer was to place their own noncustodial wallet in a safety deposit box — for example at a Foreign Financial Institution (FFI) in which the institution has access to the box. In this case, the value of the digital assets may have to be included when reporting the total value of the foreign safety deposit box. While the general rule is that foreign safety deposit boxes are not reportable, if the box can be accessed by the FFI, then it can become reportable.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to streamlined procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead of the Streamlined Procedures. But, if a willful Taxpayer submits an intentionally false narrative under the streamlined procedures (and gets caught), they may become subject to significant fines and penalties

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