Back when I had a semi-regular series running about US Taxation and cryptocurrencies, I always ended each post by opening the floor to the community for questions which they would like to have featured with some general answers.
Almost one year later, @swansong decided to step forward and take up the offer:
- Swansong Crypto Trading Tax Questions #1
- Swansong Crypto Trading Tax Questions #2
- Swansong Crypto Trading Tax Questions #3
Quite a bit to unpack in all that, but a common question lives in the root of it all. If I’m actively trading alternative cryptocurrencies on exchanges such as Poloniex and Bitrex, do I owe capital gains tax after each trade or is the capital gains tax delayed until I convert to fiat?
Let’s take a deeper look.
But First, the Legalease…
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor is it a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
Cryptocurrencies are Defined as Property
According to the Internal Revenue Service guidance issued on March 25, 2014 Internal Revenue Notice IR-2014-36 IRS Virtual Currency Guidance, the IRS issued guidance which unequivocally states Bitcoin and all other “convertible” digital currencies (read altcoins) are taxed as property for United States income tax purposes.
Transactions Exchanging Property Covered by Barter Rules
Imagine we are trading Bitcoin and other “convertible” digital currencies on an exchange such a Poloniex or Bitrex. With the guidance issued under IR-2014-36, the IRS has effectively classified the exchange of “convertible” virtual currencies as a trade of one property for another property. This exchange would be viewed as a barter of one fairly valued property for another fairly valued property and would be subject to barter rules.
As a general rule, any time property is either sold for USD or exchanged for another property in a barter transaction (such as Bitcoin for other convertible digital currency in this case), a tax event has occurred. It requires and individual to compute the quantity (USD value) and the nature (long term or short term) of the capital gain or loss at the point of sale or exchange of the property. If you are looking for more detailed insight on how to calculate capital gains and losses, please see my earlier post US Tax Considerations When Blogging for Magic Internet Money (Part II). However, certain types of property exchanges permit the capital gains tax to be deferred until a later period when one disposes the property through sale or exchange for a different property.
Welcome to the world of Like-Kind Property Exchanges.
Section 1031 Special Kinds of Property Exchanges (Like-Kind)
For purposes of this article, the scope of the 1031 analysis will remain in the realm of convertible digital currencies.
Title 26 §1031- Exchange of Property Held for Productive Use or Investment speaks to tax advantages ascribed to exchanges of like-kind property (sale or barter) held for productive use in business or investment. The most common application of this section of the tax code is with real estate purchases for construction/land development, rental and industrial property purchases.
While any exchange of property triggers a tax event, Section 1031 of the US tax code carves out a niche for a particular kind of property exchange which permits one to defer the capital gain from the exchange until the 1031 property is disposed (sold for USD or exchanged for non-like kind property), so long as the property exchanged is of like-kind.
What makes two properties like-kind?
According to Internal Revenue Service Fact Sheet FS-2008-18: Like-Kind Exchanges Under IRC Code Section 1031, the IRS provides the following broad definition of like-kind property:
“Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is a property of the same nature, character or class.”
On the surface, the definition of like property provided by FS-2008-18 would suggest trading digital currencies (such as Bitcoin for Ethereum) on exchanges would constitute like-kind property exchanges. However, when reading through Title 26 §1031, some exceptions to this rule are outlined.
§1031 Excluded Properties and Cryptocurrencies
For purposes of this article, a specific exclusion under Section 1031 gives pause as to whether or not trading convertible digital currencies qualify for the Section 1031 like-property designation.
Title 26 §1031(a)(2)(c) This subsection shall not apply to any sale or exchange of other securities or evidence of indebtedness or interest.
It has been suggested the Internal Revenue Service may define convertible digital currencies as securities or as interests in a particular blockchain, effectively negating the ability to classify crypto to crypto trades as like-kind exchanges of property. However, no clear guidance has been issued.
Does the Trade of Convertible Digital Currencies Fall Under §1031 Like-Kind Property Exchange Rules?
It is an excellent question with no clear answer because no guidance has been issued by the Internal Revenue Service on this subject, and a host of others regarding convertible digital currency. On at least three separate occasions the IRS has been asked for guidance on this topic:
On December 31, 2013, the Taxpayer Advocate in its National Taxpayer Advocate 2013 Annual Report to Congress spoke to the lack of IRS guidance as it pertained to the regulations surrounding convertible digital currencies.
The American Institute of Certified Public Accountants seems to feel that there could be some grounds to claim a like-kind exchange of property capital gains tax deferral when trading convertible digital currencies, and on June 10, 2016, has asked the IRS for guidance in AICPA Comments on Notice 2014 – 21 Virtual Currency Guidance
On September 21, 2016, The Treasury Inspector General for Tax Administration (TIGTA) released a scathing report to Congress outlining some key areas the Internal Revenue Service is failing to enforce taxpayer compliance and clarify regulations around digital currencies. In TIGTA's report As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance one section of this report is devoted specifically to the lack of guidance provided by the Internal Revenue Service to both Tax Professionals and Taxpayers at large on a number of issues surrounding tax compliance and digital currencies.
As of the time of this writing, no new guidance has been issued. In fact, after TIGTA’s report and public hearing in Congress, the only action taken by the Internal Revenue Service on the matter of convertible digital currencies was to subpoena all user information from Coinbase in a blanket “John Doe” summons.
The takeaway from this lack of guidance leaves a ton of risk in the lap of the taxpayer.
While it would seem logical that Section 1031 would apply to a trade of cryptocurrencies (as they are deemed capital assets), this treatment cannot be confirmed without specific Federal and State guidance on the question of whether one cryptocurrency is like-kind with another. Since no guidance on this subject currently exists, 1031 exchanges of differing types of cryptocurrency, while not outright prohibited, is not guaranteed to be a tax-free exchange.
A more conservative taxpayer would calculate the capital gain on every trade. They would report out the capital gains (or losses) and pay out any capital gains tax in the year the trades were made.
A less conservative taxpayer may choose to treat the trades as §1031 Like-Kind Property Exchanges, calculate and defer the capital gains from each trade, then report out and remit all deferred tax due when they trade out into fiat. The risk with this strategy is the Internal Revenue Service could issue guidance at a later date, which excludes convertible digital currencies as like-kind property exchanges, and the taxpayer will need to amend prior period returns and face fines and penalties associated with failing to file and remit taxes due in those prior years.