IRS flags crypto ETFs using in-kind redemptions to avoid taxes

The IRS is targeting cryptocurrency ETFs that exploit tax loopholes through in-kind redemptions, a move that could reshape how digital-asset funds manage their portfolios and comply with fund taxation rules. The agency has signaled it may apply any new guidance retroactively to past transactions, creating potential exposure for funds and their investors.

• The IRS issued a notice on Monday (September 28) flagging crypto ETFs using in-kind redemptions to defer taxable gains and maintain tax-exempt status.
• Spot Bitcoin ETFs structured as grantor trusts, including BlackRock’s iShares Bitcoin Trust, appear positioned outside the notice’s scope based on their trust design.
• The IRS invited public comments by October 28 and warned that any resulting guidance could apply retroactively to transactions already completed.

• 90% Minimum income threshold from dividends, interest, and stock gains to retain fund tax-exempt status
• October 28 Deadline for public comments on the IRS notice targeting crypto ETF trading strategies

The IRS has placed cryptocurrency ETFs on notice for using a tax strategy that allows them to hand appreciated digital assets to Wall Street trading firms without booking a taxable gain, according to reporting by BeInCrypto. Most U.S. ETFs receive special tax treatment where they pay no tax themselves provided at least 90 percent of their income derives from dividends, interest, and stock gains. Profits from crypto and commodity holdings do not qualify as eligible income, putting funds at risk of losing that tax advantage if such gains exceed a certain threshold. Some ETFs have circumvented this rule by using in-kind redemptions, transferring rising digital assets to trading firms in exchange for fund shares without triggering a taxable event on the fund’s books.

Spot Bitcoin ETFs structured as grantor trusts appear to fall outside the IRS action

The IRS notice does not name specific funds, leaving some ambiguity about which products face direct exposure. Spot Bitcoin ETFs such as BlackRock’s iShares Bitcoin Trust are structured as grantor trusts. The iShares Bitcoin Trust is a grantor trust that passes its tax attributes to shareholders, according to its SEC filing. The notice specifically targets funds that hold crypto directly or through a trust entity while employing in-kind redemptions to defer income recognition. Funds holding digital assets through offshore subsidiaries fall outside the scope of the warning.

The distinction in structure may insulate major spot Bitcoin products from immediate regulatory action. However, regular ETFs holding cryptocurrency or shares of crypto trusts remain exposed to the IRS scrutiny, as those vehicles could employ the in-kind redemption technique the agency now targets.

The IRS simultaneously eliminated a parallel tax strategy used by wealthy investors

The IRS accompanied its crypto ETF notice with Revenue Ruling 2026-20, which shut down the Section 351 conversion, a separate tax strategy that allowed wealthy investors to exchange appreciating stock for a diversified fund holding without triggering capital gains tax. Under that structure, an investor would contribute appreciated stock to a new ETF, which would then pass the stock to a trading firm in an exchange. The IRS now classifies such transactions as taxable sales.

James Seyffart, an ETF analyst, posted on X that the language of the notice is broad and targets multiple specific uses of in-kind redemptions, including 351 exchanges, box spread strategies, and straddles. Ed Zollars, a CPA and author of Current Federal Tax Developments, advised tax professionals to review past client conversions for potential exposure. The Investment Company Institute, the main U.S. fund trade group, told Treasury that these conversions serve legitimate purposes including portfolio diversification and lower fees, according to law firm Liskow.

The IRS signaled it may apply new rules retroactively to completed transactions

The agency warned that guidance addressing these strategies could apply retroactively to transactions that have already taken place. This creates potential tax liability for funds and investors who executed in-kind redemptions before any new rules take effect, a significant departure from typical tax guidance that generally applies prospectively only.

The comment period closes October 28, giving fund managers, advisers, and industry groups limited time to shape the final approach. The breadth of language in the notice suggests the IRS intends to reach multiple variations of the strategy, not just a narrow subset of transactions.

The BlockWest read. Fund managers and their counsel now face immediate pressure to audit redemption practices and prepare for potential retroactive tax exposure. For institutional investors and high-net-worth individuals holding these funds, the retroactive application clause means past transactions thought to be settled may generate unexpected tax bills. The clearest near-term risk falls on regular crypto ETFs rather than spot Bitcoin trusts, sharpening incentives for funds to either restructure or disclose their compliance status ahead of October 28.

The Investment Company Institute and individual fund sponsors have until October 28 (Wednesday) to submit comments to the IRS on the notice. Their responses will signal whether the agency faces organized industry pushback or accepts the premise that in-kind redemption arbitrage should be closed. Watch for whether final guidance specifies an effective date or confirms retroactive application, as that detail will determine whether funds face immediate compliance costs or potential back-tax assessments.

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