Taxable Talk

I recently wrote an article noting that if you exchange one cryptocurrency for another you have a capital gain (or loss). I was recently asked if you could defer such a gain by using a §1031 Exchange.

What Is a §1031 Exchange? A §1031 exchange is a way of deferring the capital gain on a property by exchanging it for another property. And didn’t the IRS rule that cyrptocurrency is property? So let’s look at the statutory language of §1031:

26 U.S. Code §1031 – Exchange of Property Held for Productive Use or Investment
(a) Nonrecognition of Gain or Loss from Exchanges Solely In Kind
(1) In General No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Well, there’s the first two hurdles: Is cyrptocurrency held for productive use in a trade or business or for investment? Well, cryptocurrency likely isn’t held for productive use in a trade or business but it certainly is held by some for investment.

But that wasn’t all of 26 U.S. Code §1031. There is property that is not eligible for like-kind treatment. Let’s now look at §26 USC 1031(a)(2):

(2) Exception This subsection shall not apply to any exchange of—
(A) stock in trade or other proprety held primarily for sale,
(B) stocks, bonds, or notes,
(C) other securities or evidences of indebtedness or interest,
(D) interest in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.

There’s a problem here: The closest analog to how cyrptocurrency should be treated are stocks and bonds. And §26 USC (a)(2)(B) states that you can’t do a §1031 exchange for stocks and bonds.

“But Russ,” you say, “cyrptocurrency isn’t stocks or bonds. It’s a virtual currency. So if I exchange Bitcoin for Ethereum, that should be ok, right?” Let’s assume that §26 USC (a)(2)(B) doesn’t apply. Are Bitcoin and Ethereum like-kind property?

Unfortunately, the answer is a maybe, with “no” more likely than “yes.” The IRS has been asked to look at exchanging gold bullion for gold coins, gold coins for other gold coins, and gold bullion for silver bullion as §1031 exchanges. You can use a §1031 exchange to exchange Mexican 50 peso gold coins for Austrian 100 corona gold coins and gold bullion for Canadian Maple Leaf gold coins. However, you cannot use a §1031 exchange to exchange gold bullion held for investment for silver bullion held for investment (different metals used in different ways), $20 gold numismatic-type coins for South African Krugerrand bullion-type gold coins (different underlying investments and different valuation bases), and Swiss Francs for US Double Eagle Gold Coins (numismatic versus circulating currency).

I believe the IRS would likely rule that Bitcoin and Ethereum are two different underlying investments and do not qualify for like-kind treatment.

But let’s further assume I’m wrong, and they do qualify. You go on a Bitcoin exchange and swap n Bitcoins for x Ethereum. Is that a §1031 Exchange?

Well, there are numerous technical rules regarding a §1031 exchange. First, they must be reported on IRS Form 8824 so the idea of simply ignoring them on your tax return is a certain way to make sure your transaction is not a §1031 exchange. There are 67 pages of regulations on §1031 exchanges (search for “1031” in the link for them). Most §1031 exchanges use a Qualified Intermediary. Certainly the dealer I use is that Qualified Intermediary, right?

Well, almost certainly not. When you use an Exchange to buy a cryptocurrency, the dealer almost certainly doesn’t meet the technical requirements listed in the regulations. There is no paperwork; the trades occur close to instantly (not over the months it takes to complete a §1031 exchange); and several other issues with a dealer.

“But Russ,” you say, “my friend Scott has x Ethereum and is willing to swap it for my n Bitcoins. We agree to directly swap our positions. That would be a §1031 exchange, right?”

This is the most likely to meet IRS scrutiny, but only if the IRS considers Bitcoin and Ethereum to be like-kind. The tax professional community has asked the IRS to give guidance on this, but the IRS (to date) has ignored this issue. You could request a Private Letter Ruling from the IRS. A Private Letter Ruling is a means to get an answer from the IRS given a specific set of facts. The Private Letter Ruling binds the requestor and the IRS. However, you must pay for a Private Letter Ruling; the cost will be at least $2,400. It also takes time to receive the Private Letter Ruling (think months, not weeks).

The conclusion I’ve drawn is that most exchanges of one cryptocurrency for another do not qualify as §1031 exchanges and it’s more likely than not that the IRS will rule that two different cryptocurrencies are not eligible for like-kind treatment.

The IRS ruled that cryptocurrencies are treated as property (like stocks and bonds). What happens when a cryptocurrency splits into two separate cryptocurrencies?

Let’s start with the analogous situation with a stock. Suppose Acme Industries, Inc. spins off its subsidiary, SubCo Inc.; on October 1st stockholders of record will receive one share of SubCo for every share of Acme they own. This is almost certainly a tax-free event. (For those who care, Internal Revenue Code (IRC) Section 355 governs corporate spinoffs. Tax-free spinoffs can be accomplished either by distributing shares based on current ownership or by giving shareholders the option to exchange shares for the new spun off entity.)

Now, let’s examine a cryptocurrency split. Let’s take HYPO, a hypothetical cryptocurrency. On October 1st everyone who has 1 HYPO will still have their HYPO but will also now own 1 THET. The published goal is so that more transactions can be run through the blockchain. Will this be a tax-free event?

Probably. IRC Section 355 doesn’t apply here; this is not a corporate spin-off. That said, the analogy should hold: Presumably nothing of value has been created. If HYPO was selling for $1,000 prior to the split, the sum of 1 HYPO and 1 THET should be worth the same $1,000 after the split. If that’s the case all that’s happened is that your basis in HYPO must be split into HYPO and THET. For example, if you purchased your 1 HYPO for $500, your basis post-split in HYPO and THET must add to the same $500. There wouldn’t be a capital gain based on the split. (The allocation should be based on the fair market value of HYPO and THET immediately after the split.)

One other question that must be answered: Do you obtain the same holding period for the spin-off as you had for the original cyrptocurrency? If it’s a true split into two cryptocurrencies, definitely.

Given there has been one cryptocurrency split already (and others will certainly follow) this will give you an idea of the basics in this situation. Something that absolutely holds is keep good records! Taxes when you have good records is fairly easy. When you don’t have good records, it’s definitely not.

When I was in junior high school, I remember being taught about the 17th century tulip mania. Tulips in 1637 cost more than a house! That was a bubble (though some economists think there may have been rational explanations, let’s just call it with what it was considered to be), and my gut feeling is that cryptocurrencies are also bubbling.

I’m not the only person who has made this comparison. There’s an article on CNBC that quotes Elliott Prechter stating that cryptocurrencies are in a bubble comparable to tulips. The head of the Dutch Central Bank has also made the same comparison.

But there’s something else with cryptocurrencies: government. While the US government hasn’t formally stated that it wants cryptocurrencies to go away, the policies of the Department of the Treasury and the Department of Justice show that’s the case.

Let’s look at what two agencies within the Department of the Treasury have done in regards to cyrptocurrencies. First, the Internal Revenue Service had a choice: Should cryptocurrencies be considered currencies or should they be considered property? If currencies, most taxpayers would just enter one number on their returns for the gain (or loss). (Currency trading falls under Section 988 of the Internal Revenue Code. Gains and losses are simply entered as Section 988 transactions as part of line 21 (“Other Income”) on Form 1040.) This would be simple and straightforward. Instead, the IRS ruled that cryptocurrencies should be treated as property. That means each time you use or sell a cryptocurrency you have a reportable capital gain or loss. That’s a much tougher recordkeeping requirement.

Meanwhile, the Financial Crimes Enforcement Network (FINCEN) ruled exactly the opposite. For FINCEN purposes, cryptocurrencies are currencies, not property. That means cryptocurrencies fall under the purview of FINCEN. If you are an active seller of cryptocurrencies to others, you may have to register and are subject to the money transmittal rules. (FINCEN has said “miners” and investors of cryptocurrency are not money transmitters.) FINCEN has gone after foreign (non-US) based wallets, too.

The US Department of Justice has prosecuted US individuals who have been selling Bitcoins.

Perhaps I’m cynical (well, I know I am), but it appears to me that the US government’s actions are designed to make cyrptocurrencies appear more unattractive. That to me is more likely than not to put downward pressure on cryptocurrencies.

I should point out that friends of mine who are far smarter than I am think that Bitcoins will be worth $10,000 in the near future (as I write this, the price of a Bitcoin is about $4,100). I don’t see that. I was in the dot-com industry when that was booming and the NASDAQ would “obviously” reach 100,000. Then the bottom fell out. The cryptocurrency craze of today reminds me of that and of tulips.