Uncle Sam's Surprise: Tax Reform to Impact Crypto Investors

New provisions in the upcoming tax reform bill could have several significant repercussions on crypto holders this tax season.

AccessTimeIconDec 13, 2017 at 1:15 p.m. UTC
Updated Sep 13, 2021 at 7:16 a.m. UTC
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The U.S. tax code is on the brink of its largest overhaul in three decades.

And while neither the House of Representatives or Senate version of the tax bill (both have passed in their respective chambers and are in the process of being reconciled into a final bill) specifically addresses cryptocurrency, several rule changes could potentially catch bitcoin holders who realized eye-popping gains in 2017 by surprise.

So far, both versions scrap the "like-kind" exchange mechanism that many cryptocurrency holders have used in the past and the Senate version proposes a "first-in, first-out" (FIFO) accounting framework, which could complicate cryptocurrency token reporting.

Yet, the proponents of the reform, including President Donald Trump and the majority of Republicans on Capitol Hill, argue the goal is to make paying Uncle Sam far less torturous of a process for everyone.

Representative David Schweikert, the Arizona Republican who serves as the co-chair of the Congressional Blockchain Caucus and the Ways and Means Committee, which oversees taxation, told CoinDesk:

"With a more simplified tax code, individuals will be able to navigate the challenges that bitcoin and cryptocurrencies face with more ease."

Unfortunately for crypto-holders, the Cryptocurrency Tax Fairness Act – of which Rep. Schweikert is a co-sponsor – was left out of both versions. Neither version modifies existing capital gains tax rates, which cryptocurrency is subject to pursuant to the IRS' 2014 guidance.

Swapping crypto

Yet, the final bill will almost certainly do away with a crypto-friendly maneuver – deferring capital gains taxes on property by swapping one asset for a similar asset via a so-called 1031 like-kind exchange.

Employing such exchanges has been a common tactic in crypto trading circles in years past, but both the House and Senate bills limit this provision solely to real estate transactions.

"A lot of people have been taking the position that when they swap tokens from one type of token to another type of token or one cryptocurrency to another cryptocurrency, that’s a like-kind exchange," said Lisa Zarlenga, partner at Steptoe & Johnson in Washington, D.C. and co-chair of the firm's tax group.

By swapping between cryptos, asset owners forego the short-term capital gains tax – the same as ordinary income tax rates – and then pay a lower long-term capital gains tax rate of 20 percent when the asset is sold.

According to Kelsey Lemaster, partner at Goodwin Procter in San Francisco, while current law is unclear whether this like-kind mechanism can be applied to cryptocurrencies, a good argument could be made for it in the case of swaps of assets that originate from the same blockchain, such as bitcoin to bitcoin cash.

"But then if the proposals go through, they would eliminate the ability to take this position on any exchange of crypto," Lemaster said.

First in, first out

What is more of a wild card, though, the FIFO accounting mechanism for "specified securities" could have the biggest potential impact on cryptocurrency holders.

The requirement, only a provision within the Senate version, means that, as it relates to determining the cost basis of an asset sold, the oldest goods in one's inventory would be the first to be sold.

"Normally, what you would do is tell your broker to sell the highest-cost ones first. What [the Senate] is proposing is that you can’t use that anymore, that you have to use first-in, first-out," said Jim Calvin, tax partner at Deloitte, explaining:

"So, the first stuff that you bought would have to be the first stuff that you were treated as selling."

As an example, if a person bought one bitcoin at $1,000 in 2013 and another at $10,000 last month, and then decides to sell one at $15,000, that individual must sell the one bought first – the $1,000 one – and realize $14,000 worth of taxable gains (what they'd likely rather do is sell the $10,000 one first, and realize only $5,000 of taxable gains).

While the Commodities Futures Trading Commission (CFTC) has categorized bitcoin a commodity, many wonder whether this provision, since it only applies to securities, would affect bitcoin. According to Calvin, bitcoin will likely get caught up in this, because bitcoin futures started trading this week.

And even if bitcoin gets a pass, Zarlenga contends several initial coin offering (ICO) issuers, who have designed their tokens as securities, plus the issuers the SEC continues to go after, will fall under the FIFO umbrella.

"You can have tokens that have enough qualities of a security to be treated as a security for tax purposes," she said.

Silver lining

As daunting as FIFO may be, though, it’s not certain that the provision will be in the final bill signed into law.

Since the House and Senate are currently reconciling their respective drafts, and FIFO was only in the Senate's version, it could very well be axed. Especially since many powerful interests, such as the Investment Company Institute – which represents firms in the regulated funds business – are calling for its removal.

Yet, even if it does stay on the bill, there's some good news on the FIFO front, according to Deloitte's Calvin.

For one, the provision only applies account-by-account, meaning that if the oldest bitcoins an individual owns are stored in a separate account from the bitcoins they want to sell or better yet, outside of an exchange account altogether, the rule does not apply.

"If you sell bitcoin (in 2018), you’re going to be treated as selling the first one that you bought," Calvin said. "So, take it off the exchange, hold it directly and when you want to sell one, you can deliver the one you want to sell."

Practicing what he preaches, Calvin added, that he personally is taking all his crypto off of exchanges before the end of the year.

Going a step further, Lemaster said traders may want to consider selling off a significant chunk of their crypto holdings before the end of the year to minimize the capital gains realized.

He concluded:

"If people are planning to sell bitcoins in the near future, it might be worthwhile for them to sell before the beginning of the year."

Uncle Sam pig image via Shutterstock


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