IRS Warns Crypto ETFs Over Tax Loophole Risks

The Internal Revenue Service has warned crypto ETFs and other investment funds about tax strategies that use in-kind redemptions to avoid recognizing gains, signaling potential changes that could affect parts of the digital asset fund industry.

In a notice issued Monday, the IRS focused on regulated investment companies that hold cryptocurrencies, commodities, or interests in trusts owning such assets. U.S. funds generally receive favorable tax treatment if at least 90% of their income comes from qualifying sources such as dividends, interest, and securities gains. Crypto and commodity profits may not qualify.

Some ETFs have sought to manage this issue through in-kind redemptions. Instead of selling appreciated digital assets and recording taxable gains, a fund can transfer assets to trading firms redeeming ETF shares. Existing rules can allow these transfers without the fund immediately recognizing a gain.

The IRS said its concerns can apply whether funds own digital assets directly or through certain trusts. However, the notice does not identify individual ETFs. Spot Bitcoin products structured as grantor trusts, including BlackRock’s iShares Bitcoin Trust, operate under a different tax framework in which tax attributes generally pass through to shareholders.

Funds holding crypto assets or shares of crypto trusts could face greater scrutiny, while structures using offshore subsidiaries appear to fall outside the scope of the notice. The IRS also warned that future guidance could potentially apply retroactively to transactions that have already occurred. Public comments are due October 28.

Separately, the IRS issued Revenue Ruling 2026-20 targeting Section 351 ETF conversions. The strategy allowed investors with highly appreciated stocks to contribute those holdings to a newly formed ETF and receive diversified fund shares without immediately triggering capital gains taxes.

Under the new ruling, certain transactions in which contributed securities are subsequently transferred through ETF redemption mechanisms will be treated as taxable sales.

The two actions indicate increased IRS scrutiny of tax-aware ETF strategies that use in-kind transfers to defer or avoid recognizing gains. Fund managers, advisers, and investors may now need to reassess existing crypto ETF structures and previous Section 351 conversions as the Treasury and IRS consider additional guidance.