What is this Stuff? Tax Planning Considerations for Investors in Virtual Currency

Virtual currency (or cryptocurrency) trading has captured the attention of private investors and seems to be more than a passing fad.

Unfortunately, guidance from IRS pertaining to related income tax issues has not kept pace with the proliferation of virtual currency trading. This article highlights key income tax compliance issues for investors dealing or transacting in virtual currency.

Capital Gain Treatment and Holding Period

The classification of virtual currency for tax purposes remains unsettled. The only guidance provided by IRS with respect to virtual currency to date is Notice 2014-21 (the Notice), which defines convertible virtual currency such as Bitcoin or Ethereum as property rather than currency for income tax purposes. Thus, the general tax principles applicable to property transactions should apply to virtual currency transactions. Accordingly, it follows that the character of the gain or loss from the sale of a virtual currency depends on whether the virtual currency is a capital asset in the hands of a taxpayer. For most casual investors, virtual currency will be a capital asset. To determine the gain or loss on a sale, a taxpayer must compare the fair market value of the virtual currency in U.S. dollars on the date of the transaction to the fair market value in U.S. dollars on the date acquired (cost basis). If the fair market value on the date of the transaction is higher than the cost basis, the taxpayer has a capital gain (if the cost basis is higher there is a capital loss). The holding period starts on the date acquired and will determine whether the capital gain or loss is taxed as short-term or long-term. If the virtual currency is held by an investor as a capital asset for more than one year from the date acquired, the gain or loss from the sale will be taxed at preferential long-term capital gain rates.

Gain Deferral and Like-Kind Exchanges

Although the issue of whether virtual currency qualifies for like-kind exchanges has been rendered moot by the new tax law (beginning in 2018, only real property will qualify for like-kind exchange treatment), the analysis is nonetheless helpful in considering the broader tax issues around virtual currency and does remain relevant for prior tax years. As most of those trading in virtual currency know, Bitcoin is not the only game in town. In fact, most investors frequently trade between different currencies, for example, using Bitcoin to buy Ethereum. The question of whether exchanging one virtual currency for another is a sale or exchange that results in taxable income is unanswered.

An exchange of property occurs for tax purposes if there is a material difference between the two properties exchanged. A material difference exists between two properties so long as they embody legally distinct entitlements. Imagine a taxpayer exchanged Bitcoin for Ethereum, two types of virtual currencies. Do these two virtual currencies have different legal entitlements that would therefore constitute different properties? If the answer is yes, it would seem that the exchange of Bitcoin for Ethereum would constitute a realization event.

Assuming the exchange of two different virtual currencies is a taxable exchange, could an investor reasonably argue it should be considered a like-kind exchange which can be deferred under Sec. 1031 of the Internal Revenue Code (the Code) for tax years prior to 2018? The like-kind exchange rules are used to defer gain when property held in a trade or business or for investment is exchanged for other property of like-kind (i.e., of the same nature or character). The like-kind exchange regulations exclude specific property like stocks, bonds, notes, or other indebtedness from qualifying, but do not specifically exclude virtual currency. Of course, these regulations were written long before virtual currency existed. The regulations do provide that intangible assets can be like-kind if they represent similar rights and the underlying assets are similar. To support a like-kind exchange position, a taxpayer would need to argue that two types of virtual currency (e.g., Bitcoin and Ethereum) confer the same rights, which may be difficult to do.

In addition to a like-kind exchange, the exchange of units of virtual currency could be considered similar to the exchange of two pieces of property, or barter. As a result, there may be reporting requirements. IRS has not expressly compared the exchange of virtual currency to a barter transaction, but taxpayers dealing in virtual currency should be aware that concepts underlying IRS’ policy on barter (such as the constructive receipt doctrine) could be applied to virtual currency.

Charitable Contributions

Generally speaking, one way to manage the capital gains tax on appreciated property is through charitable giving. Virtual currency prices have surged to stratospheric levels over short periods of time, leaving investors with large unrealized gains. Recognizing this value, Donor Advised Funds (DAFs) and other qualifying charities have begun accepting Bitcoin and Ethereum donations and therefore charitable giving has become a viable way to manage the taxes on virtual currency gains. There are, however, a few potential traps for the unwary. First, in order to benefit from a deduction for the fair market value of donated property, a taxpayer must hold the asset for more than one year. Given the rapid increase in value of Bitcoin and other virtual currencies, most new investors will not meet the holding period requirements and will only receive a deduction for the cost basis of their virtual currency assets. Secondly, despite the availability of market prices on Coinbase and similar trading platforms, it is not clear that virtual currencies will be considered qualified appreciated property for which a quotation is available on an established securities market as is required by Sec. 170(e)(5)(B)(i) of the Code. Thus, it may be necessary to obtain a qualified appraisal of virtual currency assets donated to a charity. Finally, since the prices of virtual currencies can fluctuate so wildly (even within an hour), as a practical matter it may be difficult to pinpoint the value of the virtual currency donated. When donating marketable securities, the value of the donation is generally the average of the high and low stock price for the day of donation. Given this formula and the realities that Bitcoin prices for example can change 10% to 20% in a day, a donor may not get the anticipated deduction.

Tax Lot and Wash Sale Considerations

While IRS has not opined as to whether virtual currency should be treated as a security, the Securities and Exchange Commission (SEC) is treating virtual currency as such. The distinction is important for purposes of identifying the cost basis of virtual currency assets sold during the year. If a taxpayer were to treat virtual currency as a security, and IRS is treating virtual currency as property and not currency, it would follow that tax lot rules used for determining cost basis of securities sold should also apply. If an individual owns one lot of Bitcoin with a basis of $1,000 and another lot of Bitcoin with a basis of $9,000, it seems reasonable that he or she can choose which lot to use in a sale or exchange. However, because virtual currency exchange platforms usually do not keep track of basis like securities exchange platforms do, it is important for taxpayers to carefully keep track of their own basis. Without an established method to track basis and accurate record keeping, a taxpayer may be forced to use an arbitrary method for determining basis when selling or exchanging virtual currency. Given the volatility of various virtual currencies, determining which particular lot is sold can have an enormous impact on the tax paid.

In a related issue, taxpayers transacting with virtual currency must also consider IRS wash sale rules applicable to the sale of stocks and securities. Under the wash sale rules, the loss on the sale of a security is disallowed when a taxpayer sells or trades a security at a loss and purchases a substantially identical security within 30 days before or after the sale. Since IRS has not opined whether virtual currency is a security it is unclear whether the wash sale rules should apply.

Bitcoin Cash – Is it Taxable?

It is not uncommon for owners of a specific virtual currency to change the code underlying the blockchain (i.e., a continuously growing list of records linked and secured using cryptography). For example, they may do this to improve security features of the blockchain. As a result, existing virtual currency owners receive rights to a new virtual currency without giving back any of the old currency, an event known as a fork. The most notable fork occurred in 2017 when Bitcoin holders received a new currency called Bitcoin Cash (BCash). A fork seems to be an entirely new type of event and analysis of the income tax implications falls into uncharted waters. Unfortunately, IRS has not issued any guidance regarding how they will view a fork so taxpayers need to consider different tax treatments.

  • Should a fork be treated like a dividend? Since virtual currency is not considered a corporate security, it seems unlikely that the dividend rules would apply since they are for distributions of cash or property out of the earnings of a corporation.
  • Should a fork be treated like a property division that may be tax-free under the same rules that govern a stock split or spinoff? A division of corporate stock will create taxable income for the shareholder unless it is structured properly to fit under certain exceptions that are specifically written into the Code. Those exceptions fall under corporate tax law that applies to stocks and securities. Since virtual currency is not classified as a stock or security for tax purposes, it is hard to conclude that a fork falls under those exceptions. An analogy could be made to a tax-free property division such as dividing one parcel of real estate into two or more. However, in such a case no new property is created, so the analogy to a fork, where a second virtual currency distinct from the first is created and there is no diminution of the first, may not fit.
  • Should a fork be treated as ordinary income? Based on the above, it would seem that the most realistic position is that the value of the new currency received in a fork should be ordinary income, but such position is conjecture. It is unlikely to be considered capital gain as there was no sale or exchange of a capital asset. Likewise, since IRS has indicated virtual currency is not actually currency, a fork would not be considered a currency exchange.

Information Reporting

Along with numerous uncertainties in the taxation of virtual currencies, taxpayers also face information reporting issues due to the lack of records and regulations. Of course, these issues do not exempt taxpayers and vendors from information reporting requirements. If a taxpayer receives wages in the form of virtual currency, the fair market value of the virtual currency paid as compensation should be reported on Form W-2, and those wages are still subject to federal income tax withholding. Likewise, if paid as other income for the performance of services, the information reporting requirements for Form 1099 apply as well. In addition, as indicated above taxpayers are also responsible for keeping track of their cost basis and reporting gains and losses, even if the exchange platform they use does not. These inherent complications promise to create reporting questions for both taxpayers and their advisors.

The Takeaway

Determining the tax implications of virtual currency transactions for investors is complicated and, unfortunately, IRS has thus far provided little guidance to help along the way. Limited legislation has been proposed but to date has not gathered widespread support in Congress. In the absence of clear guidance, each virtual currency transaction should be analyzed based on its specific facts and circumstances. Due to the uncertainty regarding the proper tax treatment and reporting of virtual currency transactions, it is important to consult with a tax specialist who is familiar with these issues.