IRS Notice Targets Crypto ETFs Using In-Kind Redemption Tactic

The IRS has warned crypto ETFs in a Monday notice. It targets funds holding digital assets that employ a trading method to avoid recording gains.

On the same day, the IRS ended a tax-free stock swap used by wealthy investors. Both actions stem from the same ETF regulation.

How Crypto ETFs Keep Gains Off the Books

Most U.S. ETFs benefit from a special tax status. They are exempt from paying taxes provided that at least 90% of their income comes from dividends, interest, and stock gains.

Gains from cryptocurrencies and commodities do not count. Too much such income puts the tax break at risk.

According to the IRS, some ETFs have found a workaround. They transfer appreciating digital assets to Wall Street trading firms, which then redeem fund shares. A regulation permits these transfers without the ETF recording a taxable gain.

ETF analyst James Seyffart noted on social media that the notice targets several specific uses of in-kind redemptions to manufacture or defer tax outcomes, including Section 351 exchanges, box spread strategies, and straddles.

Without a recorded gain, no adverse income arises. The notice states that this applies whether the fund holds assets directly or through a trust.

Which Crypto Funds Are at Risk

The notice does not name specific funds. Spot Bitcoin ETFs like BlackRock’s iShares Bitcoin Trust are structured differently; the trust is a grantor trust that passes tax attributes to shareholders, per its SEC filing.

The risk applies to conventional funds that hold crypto or shares of such trusts. Funds that hold these assets via an offshore subsidiary fall outside the notice.

The IRS cautioned that any remedy might be applied retroactively.

“Any such guidance could apply prospectively only or retroactively to transactions that already have taken place…”

Public comments must be submitted by October 28.

The IRS Also Shut Down a Tax-Free Stock Swap

The warning accompanied Revenue Ruling 2026-20. That ruling eliminates the Section 351 conversion, which previously allowed wealthy investors to exchange appreciated stock for a diversified fund without tax consequences.

“Sounds like it’s just cracking down on ones that break from spirit of law,” noted Eric Balchunas, an ETF expert.

Under the old structure, an investor would contribute shares to a new ETF. The fund then transferred those shares to a trading firm. The IRS now considers that transaction a taxable sale.

Ed Zollars, a CPA and author of Current Federal Tax Developments, advised tax professionals to examine past client conversions.

The Investment Company Institute (ICI), the largest U.S. fund trade association, informed the Treasury that such conversions provide diversification and reduced fees, as reported by law firm Liskow.