2017 will be remembered as the year of the “crypto”. Traders in the cryptocurrency asset class were making returns 10x -100x that of their initial investment. The amount of money invested in this space has risen from around $16B at the beginning of 2017 to over $600B by the start of December 2017. Roughly a 37x increase in market activity in a period of less than 12 month.
Cryptocurrency Defined
A cryptocurrency is a digital currency where encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds. In most cases, no single entity controls the currency, and it’s resistant to fraud and tampering. Every peer in the network has a record of the complete history of all transactions and thus the balance of every account. Such consensus and the shared ledger accountability are how blockchain cryptocurrencies stand out and are a large part of the reason why Bitcoin has become a hot topic for investors.
Types of Cryptocurrency Transactions
If you traded, invested, or exchanged cryptocurrency during 2017 you have to report a capital gain or loss on each transaction to include coin-to-fiat sales, coin-to-coin trades, and purchases of goods or services using a cryptocurrency. Some coin transactions create taxable income, including master node rewards, mining income, and coin-to-currency trades. Keep good records of coin fees and other expenses.
Examples:
- You sold Bitcoin for US dollars is a capital gain or loss reportable on Form 8949 (IRS Notice 2014-21)
- Coin-to-Coin. A trader/investor buys bitcoin with USD; sells Bitcoin to buy Ripple
- A miner receives a coin for his work, he or she recognizes business revenue based on the fair market value of the coin (SE Income) (IRS Notice 2014-21)
- A master node owner earns rewards from ownership. Master node income is treated as other Income at fair market value (SE Income) (IRS Notice 2014-21)
- Coin-to-Coin. A trader/investor buys bitcoin with USD; sells Bitcoin to buy Ripple
- A taxpayer who receives convertible virtual currency as payment for goods or services must include in gross income its FMV, measured in U.S. dollars, as of the date the virtual currency is received.
Tax Treatment of Virtual Currency
The IRS has released Notice 2014–21, which views cryptocurrencies as “convertible virtual currency”. The IRS explains that “Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as ‘convertible’ virtual currency. Bitcoin is one example of a convertible virtual currency.” Generally, the IRS will treat convertible virtual currency as “property” using established tax principles applicable to property transactions.
What does that mean? Essentially, its saying that trading crypto is the same as trading stocks (i.e. each individual transaction of a token or coin creates a taxable event subject to short term/long term capital gain rates). By treating Bitcoin and other virtual currencies as property and not currency, the IRS is imposing extensive record-keeping rules and significant taxes on its use. If the fair market value (FMV) of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the FMV of the property received is less than the adjusted basis of the virtual currency.
A coin position held for one year or less is considered a short-term capital gain taxed at ordinary income tax rates (up to 39.6% for 2017 and 37% for 2018). A coin position held longer than one year is considered a long-term capitalgain taxed at capital gains rates (up to 20% for 2017 and 2018).
Capital losses offset capital gains in full, and a net capital loss is limited to $3,000 against other types of income on an individual tax return. An excess capital loss is carried forward to the subsequent tax year(s), and it may not be carried back to a prior year. Some coin traders will pay massive taxes on capital gains in 2017 and get stuck with a capital loss limitation and carryover in 2018.
Like-Kind Exchange
Some investors (to include our clients) have argued that the concept of “like-kind” exchanges should apply in the crypto space. A like-kind exchange under United States tax law, also known as a 1031 exchange, is a transaction or series of transactions that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset. However, given that the recent Tax Reform Bill intends to limit like-kind exchanges to real property (i.e. land), this argument has unfortunately been taken off the table.
We do not believe the majority of coin-to-coin trades made on coin exchanges qualify for Section 1031 transactions as they fail one or both of the two primary requirements (and both are required).
- First, Bitcoin may not be a like-kind property with Ethereum.
- Second, coin-to-coin trades executed on coin exchanges do not constitute a direct two-party exchange, and coin exchanges are likely not qualified intermediaries in a multi-party exchange.
Coin-to-coin trading is similar to forex trading with different currency pairs. Various currencies are not like-kind property (i.e., U.S. dollars are not a like-kind property with yen). Each coin has its version of a blockchain, and the network of users has a different purpose for each coin. Atomic swaps or atomic cross-chain trading started in August 2017. The new technology allows a direct two-party exchange, bypassing coin exchanges. That may meet one requirement, but the coins must also be a like-kind property for Section 1031 deferral.
Final Thoughts
The current rules set forth by the IRS are going to be quite the bummer for everyone actively trading cryptocurrencies. Provided the disorganized record keeping by most exchanges (Some are even decentralized peer-to-peer exchanges), the constant transfer of funds between exchanges, the fact that most of these exchanges aren’t even U.S. based (i.e. no obligation to provide the IRS tax documents & FBAR Reporting Requirements), and the extreme volatility surrounding cryptocurrencies as a whole, most investors probably aren’t going to be ready and able to declare their gains on income that have yet to be liquidated.
Despite this, it’s always better to be safe than sorry and consult a tax professional. Having the IRS breathing over your shoulder can certainly ruin the good times if you find yourself under audit. Penalties and interests are not your friend. Invest wisely, do your own research, and know the rules.
Consult a Tax professional
There is a lot of uncertainty regarding the tax consequences of trading cryptocurrencies. If you have tax questions regarding your cryptocurrency investments, it may be in your best interest to consult a tax professional. Our firm handles multiple complex trader/investor tax issues.