Separating Myth And Reality Of How Cryptocurrencies Are Taxed And Regulated
January 31st, 2018
The following was written by our own Adam Bergman and originally appeared on Forbes.com –
Surfing the web for information on how cryptocurrencies are taxed and regulated can lead to some mystifying and conflicting information. With the IRS and SEC starting to turn attention to the cryptocurrency industry, it is important to have accurate facts. The following are some of the more popular questions I have received from clients seeking clarity on various tax and regulatory matters regarding the taxation and regulation of cryptocurrencies.
Cryptocurrency is treated as a currency for tax purposes: False.
According to IRS Notice 2014-21, for federal tax purposes, cryptocurrency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. The character of the gain or loss associated with the cryptocurrency investment generally depends on whether the cryptocurrency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of cryptocurrency that is a capital asset in the hands of the taxpayer. For example, stocks, real estate, and other investment property are typically capital assets. Whereas, a taxpayer generally realizes ordinary gain or loss on the sale or exchange of cryptocurrency that is not a capital asset in the hands of the taxpayer, such as business income from mining or other business activities.
The IRS will never be able to find out if I had taxable gains from cryptocurrency investments. False.
First, a taxpayer failing to maintain adequate records faces serious consequences. The IRS can impose penalties for negligence or fraud or require the taxpayer to use an IRS-prescribed method to determine income.
The IRS has been watching the cryptocurrency industry with some suspicion for years. Because the majority of cryptocurrency transactions have likely resulted in significant gains due to the surge in value of most cryptocurrencies in 2017 coupled with the fact that the gains are likely short-term capital gains (subject to ordinary income tax rates), the IRS has good reason to be concerned.
As a result, in a petition filed November 17, 2016, with the US District Court for the Northern District of California, the US Department of Justice (DOJ) asked the court for a John Doe summons to be issued to the Bitcoin exchange Coinbase Inc. The John Doe summons would require Coinbase Inc., the largest Bitcoin exchanger in the United States, to provide the DOJ with information related to all Bitcoin transactions it processed between 2013 and 2015. The DOJ would then share the information received with the IRS to be matched against filed tax returns. In addition, there is a good chance the IRS will be targeting other cryptocurrency exchanges through their John Doe summons power to gather additional taxpayer information on cryptocurrency transactions.
Therefore, it is crucial that any taxpayer that has generated any net gains or losses from cryptocurrencies investments in 2017 be prepared to report them on his or her individual income tax return. It is a good idea to work with a tax professional who can help calculate the aggregate annual net short-term or net long-term capital gains or losses generated from all 2017 cryptocurrency investments.
The SEC is not currently regulating the cryptocurrency industry? True & False
In a statement by the Securities & Exchange Commission (“SEC”) Chairman Jay Clayton on cryptocurrencies on December 11, 2017, Mr. Clayton was clear that the SEC has “interests and responsibilities” with respect to cryptocurrencies. Mr. Clayton did express caution for investors looking to make initial coin offering (“ICO”) investments. In addition, Mr. Clayton was clear that if an ICO shared the same characteristics of a security then it must be subject to securities laws.
In July 2017, the SEC ruled that some of the ‘coins’ for sale in an ICO are actually securities—and are subject to SEC regulation. In its ruling in the DAO case, which involved DAO, an unincorporated organization; Slock.it UG (“Slock.it”), a German corporation, the SEC essentially held that the tokens for sale are simply a new form of shares—and that selling them without a license could violate federal securities laws. The SEC ruling was based on an SEC investigation into a German corporation behind a group called the DAO, which raised $150 million in ICO last year. In addition, in December 2017, the SEC announced that its newly created Cyber Unit has filed a complaint against a Canadian initial coin offering (ICO) fraud. Moreover, state regulatory agencies are also starting to look at cryptocurrency transactions. On January 9, 2018, regulators from the North Carolina Securities Division outlined the temporary cease-and-desist, stating that BitConnect, who was seeking to do an ICO, had not registered to deal or sell securities in North Carolina.
In sum, the SEC has not gone on record holding that cryptocurrencies are securities and are, thus, subject to securities law, however, they have taken the lead in prosecuting various cryptocurrency related cases and it does appear that they are potentially heading in that direction. In any event, anyone looking to raise money through an ICO should be mindful of the SEC securities laws.
Cryptocurrencies are subject to Foreign Bank Account Reporting (“FBAR”) Rules? False
With cryptocurrency investments, taxpayers may find it more difficult to determine whether they own other financial accounts for FBAR reporting purposes. The regulations clarify that bonds, notes, and stocks of foreign issuers directly held by a reporting person aren’t financial accounts. Other financial arrangements aren’t so clear. For example, the IRS maintains that accounts that hold noncash assets, such as gold, are subject to FBAR reporting. However, the IRS has informally stated that taxpayers aren’t required to report cryptocurrency, such as Bitcoin, on an FBAR. The thinking is that cryptocurrency is treated as property for federal income tax purposes and therefore isn’t considered to be an interest in a foreign financial account. However, this could change as the agency’s attention on foreign assets heightens.
Cryptocurrencies can be purchased with retirement funds? True
The Internal Revenue Code does not describe what a retirement account can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibit “disqualified persons” from engaging in certain types of transactions, such as collectibles, life insurance, and self-dealing and conflict of interest type transactions. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the retirement account holder, any ancestors or lineal descendants of the 401(k) plan participant, and entities in which the 401(k) plan participant holds a controlling equity or management interest.
Because the IRS treats cryptocurrencies, such as Bitcoins, as a capital asset, such as stocks or real estate, a retirement account is permitted to buy, sell, or hold cryptocurrencies, subject to the prohibited transaction rules found under Internal Revenue Code Section 4975(c).
Cryptocurrencies gains can be sheltered though the 1031 Like-Kind Exchange Rules? Maybe
In general, Internal Revenue Code (“IRC”) Section 1031 provides an exception to the recognition of gain on a business or investment property transaction and allows one to postpone paying tax on the gain if the individual reinvests the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free. However, IRC Section 1031 specifically excludes stocks, bonds, notes, and other securities or debt from the definition of property under the IRC 1031 exchange exemption. In IRS Revenue Ruling 79-143, the IRS did suggest that gold coins held for investment of the same nature or character can benefit from IRC Section 1031 gain exemption.
IRC Section 1031 does not mention “cryptocurrency” since Section 1031 preceded the arrival of cryptocurrencies and IRS Notice 2014-21 does not reference IRC Section 1031 like-kind exchanges. Moreover, under the Trump tax plan, beginning in 2018, IRC Section 1031 exchanges are now only limited to real property. Therefore, for 2018 and beyond, the like-kind exchange exemption will not be applicable to cryptocurrency investors. But will the like-kind exchange exemption apply to cryptocurrencies for the 2017 taxable year? Some suggest that the fact that the tax plan narrowed the definition of property for purposes of IRC Section 1031, is proof that there was concern about the use of like-kind exchanges for cryptocurrency investments. However, there does not appear to be any evidence of this.
Overall, there is an argument that IRC Section 1031 exchange rules could apply to cryptocurrencies for 2017 so long as the crypto was held for investment purposes and was exchanged for “like-kind property.” For example, a Bitcoin held for investment purposes exchanged for ethereum could be considered a property of the same nature and character. Whereas, cryptocurrencies have not yet been defined as a stock or security or other type of property exempted from the like-kind exchange rules. Nevertheless, satisfying all the IRC Section 1031 rules could prove difficult for some cryptocurrency investors. Accordingly, taking the position that cryptocurrency gains can be sheltered using IRC Section 1031 exchange is risky and may not be respected by the IRS.
The wash rule for stocks likely do not apply to cryptocurrencies? True
Under IRC Section 1091, the IRS prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss, and within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. Currently, cryptocurrencies are treated as property by the IRS and have not been treated as a stock or security by any government agency. Accordingly, the wash sales rules are believed to not be applicable to cryptocurrencies.
The Trump Tax Plan Passthrough Tax Reduction Can Help Cryptocurrency Investors? True & False
Under the Trump tax plan, passthrough entities, such as limited liability companies (“LLC”s), would receive a deduction allowing people with pass-through income — profits from a partnership or sole proprietorship, for instance — to write off 20% of that income before calculating their taxes. Hence, cryptocurrency active traders who wish to treat themselves as a business, could avail themselves of the passthrough income deduction. However, the new passthrough income tax regime will still likely result in a higher tax rate than holding cryptocurrencies for investment or personal purposes, especially if the cryptos are being held for longer than twelve months, thus, being subject to the long-term capital gains regime.
Overall, cryptocurrency is an asset class that is still evolving. The IRS has provided some clarification as to its tax treatment under Notice 2014-21, however, some uncertainty still remains. In addition, the lack of direct guidance by the SEC and state regulatory bodies have only added more confusion.
Taxpayers should be diligent and precise when reporting cryptocurrency gains or losses to the IRS and should be cautious when taking aggressive tax positions, such as the application of like-kind exchange exemption rules. Taxpayers would be best served consulting with a tax professional for more direct guidance on these matters.