James Markwood is a Partner at Cogent Law Group in Washington, D.C.
The following article is an exclusive contribution to CoinDesk's Crypto and Taxes 2018 series.
To some, the attitude of crypto traders resembles the world of Dorothy in the Wizard of Oz.
They amble through the magical Land of Oz, following the yellow (gold) brick road, guided by a motley, sometimes bizarre, cast of characters, often oblivious to the dangers and realities of the world in which they live.
In particular, the tax world in which they live.
Many crypto traders have believed that they are “off the radar” of tax authorities, who simply won’t find out about their transactions. And, even many who do accept that they may have to report their profits from crypto have taken the position that they have no tax liability until they eventually receive “fiat” currency, and should not be taxed on coin for coin exchanges.
But, just as Dorothy realized that she wasn’t in Kansas anymore, crypto traders now are recognizing – perhaps reluctantly – that they must take into account U.S. tax liability and reporting obligations.
The IRS and the U.S. Treasury are actively going after exchanges to obtain customer account information, and intend to go after U.S. citizens, residents and non-residents who are subject to U.S. tax, regarding their gains from coin transactions.
It definitely is time for coin traders to examine their tax obligations and filing options, including whether they can defer gains under the like-kind exchange rules.
Sales and exchanges
In general, amounts realized from a sale or exchange of property are subject to U.S. tax. A sale is defined as a transfer of property for money (or a promise to pay money).
Consequently, there is little question that a sale of any crypto coin for fiat money (U.S. or foreign) is a taxable transaction in the eyes of the IRS. The seller must report the amount of any gain (or loss) in the year the disposition occurred.
But, what about exchanges of crypto coin for a different type of crypto coin?
The IRS views cryptocurrencies as property, not currency, so any exchange of crypto coins should be treated as an “exchange of property” within the meaning of the tax code (and not a “sale” of property for currency).
Such exchanges must be considered taxable unless a specific nonrecognition exception applies, and the tax regulations explicitly state that any exceptions to the general rule requiring recognition must be strictly construed.
Like-kind exchange exception
One important exception to the general rule that exchanges of property are immediately taxable is the “like-kind” exchange rule under Section 1031 of the Code.
Under Section 1031, no gain or loss is recognized if property held for investment (or for productive use in a trade or business) is exchanged solely for property of like kind.
For crypto traders, the ability to use like-kind exchange rules to avoid U.S. tax on their trades is a bit of a “good news/bad news” story.
First, the bad news. Buried deep in the massive tax bill enacted at the end of 2017 was a provision that limits like-kind exchanges to real estate transactions, effective after December 31, 2017.
As a result, there seems to be zero ability for crypto traders to claim that their coin trades undertaken after 2017 qualify as Section 1031 like-kind exchanges.
Trades before 2018
Crypto traders still may be able to argue that their transactions undertaken in 2017 and prior years were not taxable under the Section 1031 like-kind exchange rules. But, the application of the like-kind exchange rules to crypto transactions is far from certain.
One area of uncertainty is whether one type of crypto coin should be considered to be of “like-kind” with another type of coin for purposes of the Section 1031 rules. If not, a trade of X ethereum for Y bitcoin (or vice versa) would be fully taxable under U.S. tax rules. The trader would have a taxable gain to the extent the value of the coins received exceeds the tax basis of the coins relinquished.
In general, properties are of like kind if they are of the same nature or character, even if they differ in grade or quality. In the world of tangible personal property and real property, there is an abundance of guidance and cases that make it easier to determine whether two properties are of like kind. If tangible personal properties exchanged are in the same prescribed “general asset classes” (used for depreciation purposes), they qualify.
Thus, for example, an exchange of a computer for a printer is considered to be “like kind” because the two properties are in the same asset class. But, an exchange of a light duty truck for a heavy duty truck would not qualify, because they are in different asset classes.
The code specifically excludes certain intangible assets from Section 1031 like-kind exchange treatment, including stocks, bonds, notes, partnership interests, certificates of trust, and “other securities.” There is no authority treating cryptocurrencies as “securities” for purposes of Section 1031.
But, because issuance of crypto coins may be treated as an issuance of securities under federal securities law, it is possible the IRS could argue that coin exchanges are “securities” excluded from 1031 treatment.
The regulations state that exchanges of other intangible personal property qualify for nonrecognition under section 1031 if the exchanged properties are of “like kind.” The regulations do not provide asset classes for intangible assets, in contrast to tangible property. But they note that whether intangible personal properties are of a like kind to each other generally depends on the nature or character of the rights involved and the nature of the underlying property to which the intangible personal property relates.
The regulations, as well as various court decisions and IRS rulings, provide some guidance on exchanges that do and do not qualify for Section 1031 like-kind exchange treatment.
For example, these swaps would qualify for like-kind treatment, and hence the tax exemption:
- A copyright on a novel for a copyright on a different novel
- A copyright on a novel for a copyright on a song
- Gold bullion for Canadian Maple Leaf gold coins
- Gold coins minted by one country for gold coins minted by another where the coins were no longer circulating as currency
Whereas these trades would not get the exemption, and therefore are taxable:
- U.S. currency for foreign currency
- Silver bullion for gold bullion
Of these examples, the exchanges of gold bullion for gold coins, gold coins from different countries, and copyrights for different books, arguably might be analogous to exchanges of two different species of crypto coins.
Crypto coin traders who engaged in coin-for-coin trades in 2017 and earlier years should consider taking the position that their gains are deferrable under the Section 1031 like-kind exchange rules.
Of course, because there is no supporting (or contrary) authority directly addressing these transactions, there can be no guarantee that the IRS will agree that crypto coin trades qualify for Section 1031 exchange treatment.
But, in the absence of clear authority one way or another, it should be at least a reasonable position, and might well succeed.
Taxpayers who choose to report their coin-for-coin exchanges as like-kind exchanges should be mindful of their record-keeping and reporting obligations.
In particular, Form 8824 must be filed with the taxpayer’s federal income tax return, to provide information about each property given up (e.g., its acquisition date and tax basis) as well as the property received.
Traders should seek advice from a qualified tax advisor regarding their filing obligations, especially regarding filings for prior tax years in connection with amended tax returns reporting their transactions in those years.
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