Robert A. Green is a CPA and managing member of Green, Neuschwander & Manning, LLC in Connecticut.
The following article is an exclusive contribution to CoinDesk's Crypto & Taxes 2018 series.
A number of cryptocurrency traders in the U.S. are facing a tax trap.
They had massive capital gains in 2017 and have not yet paid the IRS or the state their 2017 taxes owed. However, in the first quarter of this year, their cryptocurrency portfolios significantly declined in value, and they incurred substantial trading losses.
Now, they need to sell cryptocurrencies to raise cash to pay their 2017 tax liabilities due by April 17.
That would leave many of them with little cryptocurrency to continue trading. Of course, they may choose to file their automatic extensions without tax payment or a small payment and incur a late-payment penalty of 0.5 percent per month by the extension due date of Oct. 15. (Make sure to file your return or extension by April 17. If you miss the deadline, the IRS charges a late-filing penalty of 5 percent of the amount due for each month or part of a month your return is late. The maximum penalty is 25 percent.)
If so, they’d be banking on coin prices increasing and thereby generating trading gains by Oct. 15. (It reminds me of trading on margin, except unlike a bank, the tax authorities cannot force a sale now.)The tax trap can get worse: Many cryptocurrency traders might have substantial capital losses in 2018 and get stuck with the $3,000 capital loss limitation against other income. Many will feel it's unfair to pay massive capital gains taxes for 2017 without the ability to get immediate tax relief for new losses.
Fortunately, there are a number of safer strategies traders can use to cut their tax bill, which I outline below.
Trader tax status
For starters, active cryptocurrency traders can qualify for trader tax status (TTS) to deduct trading business and home office expenses.
TTS is essential in 2018. The Tax Cuts and Jobs Act, signed into law by President Donald Trump in December, suspended investment expenses and the IRS does not permit employee benefit plan deductions on investment income.
A TTS trader can write off health insurance premiums and retirement plan contributions by trading through an S-Corp with officer compensation.
There’s a potential additional tax benefit with TTS: Electing Section 475 mark-to-market accounting (MTM) on securities and/or commodities. But for crypto traders, I have to stress the word “potential.”
Section 475 turns capital gains and losses into ordinary gains and losses, thereby avoiding the $3,000 capital loss limitation and wash-sale loss adjustments on securities (this is what I like to call "tax-loss insurance"). Ordinary losses offset income of any kind, which makes them more useful than capital losses.
As I mentioned, many crypto traders incurred substantial trading losses in the first quarter of 2018, and they would prefer ordinary loss treatment to offset wages and other income. Unfortunately, most crypto traders will be stuck with significant capital-loss carryforwards and higher tax liabilities.
There are benefits to 475 income, too. The new tax law ushered in a 20% pass-through deduction on qualified business income (Section 199A), which likely includes Section 475 ordinary income, but excludes capital gains.
Trading is a specified service activity, requiring the owner to have taxable income under a threshold of $315,000 (married) or $157,500 (other taxpayers). There is a phase-out range above the limit of $100,000 (married) and $50,000 (other taxpayers). A wage limitation also applies in the phase-out range.
But again I emphasize that 475 is not guaranteed to help crypto traders.
The IRS weighs in….
Stepping back, in March 2014, the IRS issued long-awaited guidance declaring cryptocurrency "intangible property," before regulators thoroughly assessed the sector. Section 475 is for securities and commodities and does not mention intangible property.
Over a year ago, an AICPA task force on virtual currency asked the IRS for further guidance, including if coin traders could use Section 475. The IRS has not yet replied.
...And so do the SEC and CFTC
The U.S. Securities and Exchange Commission (SEC) recently stated initial coin offerings (ICOs) might be securities offerings, which most likely need to register with the SEC. It further said cryptocurrencies or tokens might be securities, even if the ICO calls them something else.
According to the regulator, “If a platform offers trading of digital assets that are securities and operates as an ‘exchange,’ as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.”
Meanwhile, the Commodity Futures Trading Commission (CFTC) defined cryptocurrencies as commodities in 2015.
More recently, during a March 2018 CNBC interview, Commissioner Brian Quintenz said the CFTC has enforcement authority, but not oversight authority, over cryptocurrencies traded in the spot market on coin exchanges. The CFTC also has enforcement and oversight authority for derivatives traded on commodities exchanges, such as bitcoin futures.
Also in March, a U.S. district judge in New York ruled in favor of the CFTC, stating “virtual currencies can be regulated by CFTC as a commodity.”
Will the IRS change its mind?
Against that backdrop, there is a long-shot possibility the IRS could change its tune to treat cryptocurrency as a security or a commodity.
That might then fit cryptocurrency into the definition of securities or commodities in Section 475. Might. Until and unless the IRS updates its guidance, however, cryptocurrency is intangible property, which is not listed in Section 475.
The IRS has a significant workload drafting regulations to implement the new tax law, and given its limited resources, I don’t expect the agency to update its cryptocurrency guidance anytime soon.
Nevertheless, if you incurred substantial trading losses in cryptocurrencies in the first quarter, and you qualify for TTS, you might want to consider making a protective 2018 Section 475 election on securities and commodities by April 17. Even if the IRS decides to stick with its definition of crypto as intangible property, you won’t be penalized, since a protective election is provisional.
In the worst case, the election will be declared null and void. Crypto traders won’t be using Section 475 ordinary gains or loss treatment until filing 2018 tax returns in 2019. That allows one year or more for the IRS to reply to the AICPA task force. If the IRS does not permit crypto traders to use Section 475, then use capital gains and loss treatment, instead.
For the crypto traders I described at the beginning of the article, a Section 475 election would not be a savior. It turns 2018 capital losses into ordinary losses on TTS positions, but the IRS no longer allows net operating loss (NOL) carryback refunds. In prior years, a trader with this problem could hold the IRS at bay, promising to file an NOL carryback refund claim to offset taxes owed for 2017.
There is a side effect of making a 475 election on commodities: If you also trade Section 1256 contracts, you surrender the lower 60/40 capital gains rates, under which 60 percent (including day trades) are taxed at the lower, long-term capital gains rate, and 40 percent are taxed at the higher short-term rate, which is the ordinary tax rate.
Perhaps you only trade cryptocurrency and don’t care about Section 1256 contracts. If crypto is deemed a commodity for tax purposes, it’s still likely not a Section 1256 contract unless it lists on a CFTC-registered qualified board of exchange (QBE). Cryptocurrency exchanges are currently not QBEs.
Section 475 provides for the proper segregation of investment positions on a contemporaneous basis, which means when you buy the position. If you have a substantial loss in a cryptocurrency that you’ve held onto for months before the sale, the IRS will likely consider it a capital loss on an investment position.
How to qualify for TTS
Unsure if you are eligible for TTS? Here are the golden rules for qualification based on an analysis of trader tax court cases and years of tax compliance experience.
Volume: Three to four trades per day. Don’t count the times when a cryptocurrency exchange breaks down an order into multiple executions.
Frequency: Trade executions on 75 percent of available trading days. If you trade five days per week, you should have trade orders executed on close to four days per week.
Holding period: In a 2013 case, the U.S. Tax Court required an average holding period of fewer than 31 days.
Hours: At least four hours per day, including on research and administration.
Taxable account size: Material to net worth, and at least $15,000 during the year.
Intention to make a primary or supplemental living: You can have another job or business, too.
Operations: One or more trading computers with multiple monitors and a dedicated home office.
Automation: You can count the volume and frequency of a self-created automated trading system, algorithms or bots. If you license the automation from another party, it doesn’t count.
A trade copying service, using outside investment managers and retirement plan accounts, doesn’t count for TTS.
If you qualify for TTS, claim it by using business expense treatment rather than investment expenses. TTS does not require an election, but 475 does.
In 1997, Congress recognized the growth of online trading when it expanded Section 475 from dealers to traders in securities and commodities. I was urging clients and followers in chat rooms to elect 475 for free tax-loss insurance.
When the tech bubble burst in 2000, those who followed my advice were happy to get significant tax refunds on their ordinary business losses with NOL carrybacks.
I wish Section 475 were openly available to all TTS crypto traders now.
Darren Neuschwander CPA contributed to this blog post.
Tax form image via Shutterstock.