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Many cryptocurrency investors are inappropriately deferring capital gains taxes when they exchange one cryptocurrency for another. An example of this practice: exchanging Bitcoin for Ethereum through a cryptocurrency exchange and using IRC Section 1031 “like-kind” exchanges. But if you were to sell Bitcoin for U.S. dollars and buy Ethereum with U.S. dollars, you would have to report a capital gain or loss. Something is amiss!
Several websites encourage traders to consider Section 1031 on exchanges of cryptocurrencies, but none of them adequately state the potential risks.
“I suppose most people who don’t report exchanges between various cryptocurrencies don’t think of it as a like-kind exchange,” says Deborah King, CPA. “They just do it, and later when they don’t receive a Form 1099, they forget about reporting it.” That’s even worse.
The IRS thinks there is massive under reporting of income
It doesn’t sound like cryptocurrency investors, and traders are duly complying with Section 1031′s elaborate requirements. Few disclose Section 1031 transactions on the required Form 8824. A failed Section 1031 transaction bars tax deferral, and it generates current taxable income.
Recently, the IRS served a “John Doe” summons (the toughest kind) to the largest cryptocurrency exchange, Coinbase, to obtain its customer list for investors and traders with cryptocurrency transactions worth over $20,000. The IRS calculated that less than 900 taxpayers reported capital gain or losses on cryptocurrency transactions in 2015, an alarmingly small number. It’s feasible that many taxpayers inappropriately tried to use Section 1031 like-kind exchanges on cryptocurrency exchanges, and did not disclose it to the IRS on Form 8824, or otherwise.
Cryptocurrency transactions are not “covered instruments” on Form 1099Bs, so cryptocurrency exchanges/dealers did not furnish tax information to the IRS. The IRS also knows that many lawbreakers hide income in cryptocurrency transactions.
How do Section 1031 like-kind exchanges work?
Section 1031 allows a taxpayer to exchange, rather than sell, real property and personal property with another taxpayer in a tax-free exchange. You must hold the property for investment or productive use in a trade or business, and it excludes inventory. For example, enact a like-kind exchange with a commercial building for a shopping mall, or an automobile for another one, but not a truck.
According to Thomson Reuters Checkpoint, “If it’s a straight asset-for-asset exchange, you will not have to recognize any gain from the exchange. You will take the same ‘basis’ (your cost for tax purposes) in your new property that you had in the old property. Even if you do not have to recognize any gain on the exchange, you still have to report the exchange on Form 8824.” If you receive cash or other non-like-kind property (“boot”) in the exchange, you’re required to report boot as taxable income and adjust your cost basis.
Cryptocurrencies may not qualify as like-kind property
If it’s not like-kind property, it’s not a like-kind exchange. Section 1031 specifically excludes stocks, bonds, notes, and indebtedness. It does not mention “cryptocurrency” or “virtual currency” since Section 1031 predated the advent of cryptocurrencies.
“Transactions for two biggest cryptocurrencies, Bitcoin and Ethereum, are priced in different ways, and there are other fundamental differences, too,” says Darren Neuschwander, CPA.
The IRS could rule they are not like-kind property. It’s interesting to see how the IRS ruled on like-kind exchanges between coins and bullion. (Read Bitcoin taxation: Clarity and mystery. See the discussion of Section 1031 and the chart “Sec. 1031 rulings involving coins and bullion.”) In some cases, exchanges of gold for gold coins or silver for silver coins may qualify as like-kind property, but gold for silver coins is not like-kind property. An exchange of U.S. gold coins for South African Krugerrand gold coins was not like-kind property because the coins have a different composition. Krugerrands are bullion-type coins whose value is determined solely by metal content, where the U.S. gold coins are numismatic coins whose value depends on age, condition, number minted, and artistic merit, as well as metal content.
IRS hasn’t addressed Section 1031 on cryptocurrencies
In March 2014, the IRS issued long-awaited guidance (IRS Notice 2014-21) labeling cryptocurrency “intangible property,” but the IRS did not address the use of Section 1031. Investors and traders hold Bitcoin as a capital asset, so it receives capital gain and loss treatment. The AICPA and others requested further guidance from the IRS, including if investors could use Section 1031. The IRS has not yet answered in public.
With a lack of IRS guidance, using Section 1031 on cryptocurrency trades is uncertain, and I suggest wrong in almost all facts and circumstances. There is no “substantial authority” for its use, which would be required to avoid tax penalties.
Two-party vs. multi-party like-kind exchanges
Section 1031 is used most often in real property transactions, such as in commercial real estate. For example, taxpayer A wants to sell real property one (RP1), but defer capital gains taxes by doing a like-kind exchange for real property two (RP2). It’s unlikely that taxpayer B, owner of RP2 wants to do a like-kind exchange with A, which would otherwise be a “direct two-party exchange.”
It’s common for A to engage a “qualified intermediary” (QI) in a “multi-party like-kind exchange.” For example, A transfers RP1 to QI, who withholds cash payment to A. B transfers or sells RP2 to QI who then transfers RP2 to A, thereby completing A’s like-kind exchange. Section 1031 has many requirements including various procedures, documentation, and reporting. Non-compliance leads to a failed Section 1031 transaction, which negates tax deferral.
Like-kind exchanges are not happening on cryptocurrency exchanges
There aren’t direct two-party like-kind exchanges between trader A and B through the exchange. Trader A doesn’t meet or know trader B, and each executes their trades directly with the exchange.
There also isn’t a multi-party like-kind exchange. Taxpayer A trades on the exchange, and the exchange does not meet the Section 1031 requirement for acting as a QI in a multi-party like-kind exchange. The exchange does not complete any of the required paperwork as a QI, and the trades occur in nanoseconds, not over months.
The IRS would likely consider the exchange a dealer. Section 1031 prohibits dealers from participating in direct two-party like-kind exchanges since dealers hold inventory in a trade or business, not capital assets. The IRS would likely treat the exchange as a disqualified person in a multi-party like-kind exchange.
It might be possible for cryptocurrency holder A to execute a direct two-party exchange with holder B if he knows him and executes the transaction off-exchange. However, the IRS might not consider Bitcoin like-kind property with Ethereum.
Accuracy related penalties and the statute of limitations
The IRS is coming after cryptocurrency investors, traders and users to collect its share of the significant income made in cryptocurrencies since 2009. The IRS will likely assess accuracy related penalties: A negligence penalty of 20% and a substantial understatement penalty of 20% if you understate your income by 10% or more. (Read Avoiding Penalties and the Tax Gap.)
Don’t count on the year closing after three years. If a taxpayer omits more than 25% of taxable income (substantial omission), the statute of limitations expands to six years. If the IRS can establish a false or fraudulent return, or willful attempt to evade tax, or failure to file a return, then the year never closes. The John Doe summons on Coinbase reminds me of the IRS strong-arming foreign banks to bust Americans who hid income and assets in offshore bank accounts.
If you have under-reported income on cryptocurrency sales and exchanges, it’s wise to consult a cryptocurrency tax expert and consider amending prior tax returns before the IRS catches up with you. That may help with a request for penalty abatement or reduction. Hopefully, the IRS will issue more guidance on these questions soon. (Read my recent blog posts: How To Report Bitcoin Cash And Avoid IRS Trouble, and If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)
Robert A. Green, CPA
Author of Green’s 2017 Trader Tax Guide
Managing Member, Green, Neuschwander & Manning, LLC
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