Category: Cryptocurrencies

Hope For Active Crypto Traders With Massive Losses

June 16, 2018 | By: Robert A. Green, CPA | Read it on

The AICPA recently asked the IRS to permit cryptocurrency traders, eligible for trader tax status (TTS), to use a Section 475 MTM election on securities and commodities providing for ordinary gain or loss treatment.

In my March 2018 blog post Cryptocurrencies: Trader Tax Status Benefits And Section 475 Issues, I suggested crypto TTS traders consider filing a protective 2018 Section 475 election on securities and commodities, due by April 17, 2018, in case the IRS allowed it. Many crypto traders had significant losses in early 2018 with the market correction, and with a 475 election, they might avoid the $3,000 capital loss limitation using ordinary loss treatment. I said it hinged on whether the IRS changed its designation of crypto from intangible property to a security or a commodity.

The AICPA letter* implied that the IRS could keep its current classification of crypto as intangible property, yet still permit the use of Section 475.  However, it does raise other questions: The AICPA letter did not distinguish between securities and commodities, whereas, Section 475 does. TTS traders may elect Section 475 on securities only, commodities only, or both, and that has other tax implications.

If the IRS considers crypto a security, then Section 1091 wash-sale loss rules for securities would apply. Wash-sale loss adjustments are a headache and can be costly. (If you buy back a losing trade 30 days before or after, you must defer the wash-sale loss to the replacement position’s cost basis.) As intangible property, crypto is not currently subject to wash-sale losses. A Section 475 election on securities exempts TTS traders from making wash-sale loss adjustments.

If the IRS considers crypto a commodity, then a TTS trader should be able to elect Section 475 on commodities. However, that election has other tax consequences: If you trade Section 1256 contracts, including futures, you will surrender the lower 60/40 capital gains rates on 1256 contracts. For that reason, most traders elect Section 475 on securities only.

AICPA letter excerpt
8. Traders and Dealers of Virtual Currency

“Overview: Taxpayers considered dealers and traders who engage in buying and selling securities in the ordinary course of business to customers may make a ‘mark-to-market’ election under section 475. This election recognizes ordinary gains or losses on the deemed sales involved in the mark-to-market process. The securities holdings on the last day of the year are deemed as sold for their fair market value resulting in both ordinary income and ordinary expenses the same as for any other trade or business. Taxpayers who trade virtual currencies perform this activity on virtual currency exchanges that contain all the robust trading features available on trading platforms for securities and commodities, including the same level of liquidity. In this context, virtual currencies are akin to securities and commodities. This particular issue is also under consideration by the Commodity Futures Trading Commission.

Suggested FAQ
Q-22: May taxpayers who trade virtual currency elect the mark-to-market rules under section 475 if they otherwise qualify as a dealer or trader?

A-22: Yes. The nature of virtual currency trading is akin to dealers and traders of securities and commodities and a taxpayer may elect mark-to-market treatment. The taxpayer must otherwise qualify as a dealer or trader in order to make the election.

* The IRS has made no indication that they intend to adopt all, or any, of the many excellent recommendations from the AICPA.

SEC update
On June 14, CNBC reported, “The SEC’s point man on cryptocurrencies and initial coin offerings (ICOs) says that bitcoin and ether are not securities but that many, but not all, ICOs are securities and will come under the regulatory control of the SEC and relevant securities laws.”

The official explained what constitutes a security in the eyes of the SEC. An initial coin offering is likely a security because a third-party company, which is not decentralized ownership, sells an investment product to the public. The sponsor uses the money raised for its internal use. The buyer/investor expects a profit — a return on the investment. Conversely, bitcoin and ether are likely not securities because there was no ICO, ownership is decentralized, and they were not sold as investments.


Spending Crypto For Personal Use Can Be A Tax Mistake

June 4, 2018 | By: Robert A. Green, CPA | Read it on

If a taxpayer purchases virtual currency (cryptocurrency) and spends it on personal use, the IRS requires him to calculate a capital gain or loss on each transaction. Capital gains on personal-use property are reportable and subject to tax, whereas, the IRS disallows capital losses.

The AICPA recently asked the IRS for some equitable relief by adopting a “de minimus election,” which provides a $200 threshold for excluding capital gains income on personal transactions. (See the AICPA letter and an excerpt of the de minimus rule proposal below.)

If a taxpayer acquires virtual currency as an investment, though, then all capital gains and capital losses are reportable, and the de minims rule should not apply.

The AICPA suggests the IRS apply a similar de minimus rule used for foreign currency transactions in Section 988(e)(2) (see below). The code section refers to personal purchases, not Section 162 business or Section 212 investment property. For example, if a taxpayer acquired Euros for a European vacation, the de minimus rule applies, and the taxpayer can exclude capital gains on the Euros spent if the capital gain is under $200 per transaction.

The IRS does not permit taxpayers to deduct capital losses on personal-use property, including foreign currency or virtual currency held for personal use. Taxpayers may not deduct capital losses on the sale of a private auto or a primary residence.

Examples of using crypto for personal use vs. investment property

1.    Joe purchased one Bitcoin in early 2017 for personal-use spending, and his Bitcoin rose in price substantially during the year. Joe planned on many vendors adopting Bitcoin as a means of payment. Joe’s original intention was for personal use, so a de minimus exemption should apply to him if the IRS approves that AICPA recommendation*. If Joe bought Bitcoin in 2018, he might have a capital loss, which would be non-deductible on personal-use property.

2.    Nancy invested in 10 Bitcoins in early 2017, and her intention was capital appreciation and diversification into a new asset class. She spent Bitcoin frequently during the year on personal transactions, buying goods and services wherever Bitcoin was accepted. She hoped it would be tax-free, but it’s not.

The intention of the taxpayer is critical in determining tax treatment. If the aim is for personal use, then the de minimus rule should apply to capital gains under $200, and capital losses are not deductible. If the intention is for investment, then it’s capital gains and losses. If the purpose is for business, ordinary gain or loss treatment applies.

With tax treatment hinging on category (personal use, investment, and business), it’s wise to segregate cryptocurrency into these buckets carefully. If the IRS agrees with the AICPA proposal on the de minimus exemption, declare a crypto wallet for personal use, and the rest as an investment to protect capital loss treatment on the bulk of your crypto that you don’t plan to spend.

Excerpt from the AICPA letter
4. Need for a De Minimis Election

“Overview: Some taxpayers may only have a minimal amount of virtual currency that is designated for making small purchases (such as buying coffee). Tracking the basis and FMV of the virtual currency for each of these small purchases is time consuming, burdensome, and will yield a de minimis amount of gain or loss. A binding election applicable for a specified amount of virtual currency is beneficial to taxpayers.

Currently, section 988(e)(2) allows for an exclusion of up to $200 per transaction for foreign currency exchange rate gain, if derived from personal purchase. The same exclusion should apply to virtual currencies even though they are considered property rather than foreign currency.

Suggested FAQ

Q-9: May individuals use a de minimis rule for virtual currency similar to the section 988(e)(2) exclusion of up to $200 per transaction for foreign currency exchange rate gain?

A-9: Yes. Individuals may use a de minimis rule, similar to section the 988(e)(2) exclusion, for virtual currency transactions to alleviate the burden or recordkeeping for individuals who use virtual currency as a medium of exchange. This de minimis rule allows taxpayers to exclude transactions resulting in $200 or less of gain.”

Section 988(e)(2) Exclusion for certain personal transactions
“If—

(A) nonfunctional currency is disposed of by an individual in any transaction, and

(B) such transaction is a personal transaction,

no gain shall be recognized for purposes of this subtitle by reason of changes in exchange rates after such currency was acquired by such individual and before such disposition. The preceding sentence shall not apply if the gain which would otherwise be recognized on the transaction exceeds $200.

(3) Personal transactions. For purposes of this subsection, the term “personal transaction” means any transaction entered into by an individual, except that such term shall not include any transaction to the extent that expenses properly allocable to such transaction meet the requirements of—

(A) section 162 (other than traveling expenses described in subsection (a)(2) thereof), or

(B) section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).”

(Note: Section 162 is for business, and Section 212 is for investments.)

* The IRS has made no indication that they intend to adopt all, or any, of the many excellent recommendations from the AICPA. 


Accounting Method Impacts Crypto Income Taxes

April 10, 2018 | By: Robert A. Green, CPA | Read it on

Many crypto traders face massive tax bills for 2017. Which accounting method they apply could change their tax bills by tens of thousands of dollars.

Specific identification vs. FIFO
The IRS wants the “specific identification” (SI) accounting method used on property transactions, which applies to crypto. SI requires “adequate identification” of units sold, but most crypto traders cannot comply with these formal IRS regulations.

Many crypto traders and accountants use the alternative “first in first out” (FIFO) accounting method. FIFO is reliable and practical. A side benefit of FIFO is longer holding periods with potential qualification for long-term capital gains tax at 0%, 15%, and 20% graduated rates.

But FIFO likely raised tax bills for many crypto traders in 2017, because coin prices rose dramatically during the year. Selling coins purchased at lower prices (cost basis), increased 2017 capital gains. Many traders held significant amounts of crypto at year-end, embedded with higher cost-basis. If these traders complied with SI adequate identification rules, they might have reduced capital gains income by choosing higher-cost lots for sale.

Special IRS rule for securities
Thomson Reuters tax publishers explains the FIFO rule as follows:

“Except for stock for which the average basis method is available (i.e., mutual fund shares), if a taxpayer sells or transfers corporate stock that the taxpayer purchased or acquired on different dates or at different prices, and the taxpayer doesn’t adequately identify the lot from which the stock is sold or transferred, the stock sold or transferred is charged against the earliest lot purchased or acquired to determine the basis and holding period of the stock.

“An adequate identification is made if the taxpayer, ‘at the time of the sale or transfer,’ specifies what particular shares are to be sold or transferred and, within a reasonable time after that, the broker or other agent confirms the specification in a written document. In this event, the taxpayer’s instruction prevails even though delivery was actually made from a different lot. Stock identified under this rule is considered to be the stock sold or transferred by the taxpayer, even if stock certificates from a different lot are actually delivered to the taxpayer’s transferee. For this purpose, an adequate identification of stock is made at the time of sale, transfer, delivery or distribution if the identification is made no later than the earlier of the settlement date or the time for settlement required by Rule 15c6-1 under the Securities Exchange Act of 1934. A standing order or instruction for the specific identification of stock is treated as an adequate identification made at the time of sale, transfer, delivery or distribution.”

The tax court and IRS relaxed SI rules in some cases, but more stringent IRS regulations remain the law. In Concord Instruments Corp, (1994) TC Memo 1994-248, per Thomson Reuters,

“Taxpayer had maintained cost records of each lot of stock that was purchased, the date of purchase, and the price per share. T’s accountant used these records to prepare T’s income tax returns. To compute the gain from T’s stock sales, the specific identification method was used and the highest cost shares were treated as sold first. The court concluded that Taxpayer had sufficiently identified the stock sold to avoid the FIFO method of reporting the gains.”

The tax court allowed oral communication by the trader to the broker and the court relaxed the broker rules for providing contemporaneously written confirmation.

With high-speed trading on coin exchanges, it seems nearly impossible to comply with adequate identification rules for the SI accounting method. Crypto traders don’t use brokers; they trade online over coin exchanges without any communication between trader and exchange. Would the IRS consider this situation to be compliant with SI adequate identification rules? Maybe not.

New York tax attorney Roger D. Lorence says: “Given how longstanding this regulation is, I would describe it as having in effect the force of law.  The legal effect is to create a rebuttable presumption of its correctness; the presumption is overcome only upon the showing of strong proof.  Unless the cryptocurrency trader has contemporaneous records showing specific identification, if they are in the US Tax Court, they would be held to FIFO.”

AICPA weighs in
In June 2016, the AICPA asked the IRS if crypto traders could use FIFO as an alternative accounting method. (See Comments on Notice 2014-21: Virtual Currency Guidance.)

“Allow an alternative treatment under section 1012 (e.g., first in first out (FIFO)). The treatment of convertible virtual currency as noncash property means that any time virtual currency is used to acquire goods or services, a barter transaction takes place, and the parties need to know the fair market value (FMV) of the currency on that day. The party exchanging the virtual currency for the goods or services will need to also track the basis of all of his or her currency to determine if a gain or loss has occurred and whether it is a short-term or long-term transaction. This determination involves a significant amount of recordkeeping, even if the transaction is valued at under $10.

“Currently, there are no alternative tracking methods provided for such transactions (other than for securities under Treas. Reg. § 1.1012-1(c)). Therefore, taxpayers are required to specifically identify which virtual currency lot was used for each transaction in order to properly determine the gain or loss for that particular transaction. In many cases, it is impossible for a taxpayer to track which specific virtual currency was used for a particular transaction.”

Example of specific identification
A crypto trader bought 20 Bitcoins before 2017 at low prices. He bought 30 more Bitcoins between January and June 2017 at materially higher rates. In July 2017, he transferred the 30 Bitcoins purchased in 2017 to a coin exchange. He kept the original 20 in his wallet off-exchange. He adequately identified the 30 newer units for the trading. He used and complied with SI, and it saved him thousands of dollars in capital gains taxes compared to using FIFO.

Cherry picking
Choosing an option in a trade accounting program to cherry pick the highest cost basis for lowering capital gains after the fact is likely not acceptable to the IRS. “Last in first out” (LIFO) is also expected not acceptable.

File an extension
I suggest crypto traders file extensions for 2017 by April 17, 2018, to avoid late-filing penalties of 5% per month (up to a maximum of 25%). Hopefully, the IRS will issue new guidance addressing permissible accounting methods and their application in the real world of crypto trading.

Consult with a cryptocurrency trade accounting expert.

Darren Neuschwander CPA contributed to this blog post.

 


Cryptocurrencies: Trader Tax Status Benefits And Section 475 Issues

March 14, 2018 | By: Robert A. Green, CPA | Read it on

Active cryptocurrency (coin) traders can qualify for trader tax status (TTS) to deduct trading business expenses and home-office deductions. TTS is essential in 2018: The Tax Cuts and Jobs Act 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 in an S-Corp with officer compensation.

The benefits of Section 475
There’s an additional critical tax benefit with TTS: Electing Section 475 mark-to-market accounting (MTM) on securities and/or commodities. 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”). Many coin traders incurred substantial trading losses in Q1 2018, and they would prefer ordinary loss treatment to offset wage and other income. Unfortunately, most coin 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).

The IRS says cryptocurrency is intangible property
In March 2014, the IRS issued long-awaited guidance declaring coin “intangible property,” before regulators thoroughly assessed coin. Section 475 is for securities and commodities and does not mention intangible property. An AICPA task force on virtual currency asked the IRS for further guidance (AICPA letter), including if coin traders could use Section 475. The IRS has not yet replied. When an investor holds cryptocurrencies as a capital asset, they should report short-term vs. long-term capital gains and losses on Form 8949. (See Cryptocurrency Traders Owe Massive Taxes For 2017.)

SEC and CFTC weigh in
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 coins or tokens might be securities, even if the ICO calls them something else. According to an SEC statement, “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.” (See SEC ICO information.)

The U.S. Commodity Futures Trading Commission (CFTC) defined cryptocurrencies as commodities in 2015. During a March 7, 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 has enforcement and oversight authority for derivatives traded on commodities exchanges, like Bitcoin futures.

Also on March 7, 2018, 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.” (See Cryptos Are Commodities, Rules US Judge In CFTC Case.)

Will the IRS change its mind?
There is a long-shot possibility the IRS could change its tune to treat cryptocurrency as a security and or a commodity as a result of recent actions from the SEC and CFTC, including the statements mentioned above. Then coin might fit into the definition of securities and/or commodities in Section 475. Until and unless the IRS updates its guidance, coin is intangible property, which is not listed in Section 475.

If you incurred substantial trading losses in cryptocurrencies in Q1 2018, and you qualify for TTS, you might want to consider making a protective 2018 Section 475 election on securities and commodities by April 17, 2018 (or by March 15 for partnerships and S-Corps). The IRS has a significant workload drafting regulations for the new tax law, and with limited resources, I don’t expect it to update coin guidance shortly.

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. Perhaps, you only trade coin and don’t care about Section 1256 contracts. If coin 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 or exchange (QBE). Coin exchanges or marketplaces are currently not QBE.

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 coin that you’ve held onto for months before the sale, the IRS will likely consider it a capital loss on an investment position.

Bitcoin futures
Bitcoin futures trade on the CME and CBOE exchanges. The product appears to be a regulated futures contract (RFC) trading on a U.S. commodities exchange, meeting the tax definition of a Section 1256 contract. That means it also fits the description of a commodity in Section 475.

Section 1256 contracts have lower 60/40 capital gains tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate, and 40% are taxed at the short-term rate, which is the ordinary tax rate. Section 1256 is mark-to-market accounting, reporting unrealized gains and losses at year-end.

TTS traders usually elect 475 on securities only to retain these lower rates on Section 1256 contracts. A Section 1256 loss carryback election applies the loss against Section 1256 gains in the three prior tax years, and unused amounts are carried forward.

If a TTS trader has a substantial loss in Bitcoin futures, he or she should consider making a 2018 Section 475 election on commodities for ordinary loss treatment. (See Consider 475 Election By Tax Deadline To Save Thousands.)

Cryptocurrency investment trusts
According to Grayscale’s website, the company is “the sponsor of Bitcoin Investment Trust, Bitcoin Cash Investment Trust, Ethereum Investment Trust, Ethereum Classic Investment Trust, Litecoin Investment Trust, XRP Investment Trust and Zcash Investment Trust. The trusts are private investment vehicles, are NOT registered with the Securities and Exchange Commission.” The Grayscale cryptocurrency investment trusts list on OTC markets.

According to its prospectus, Bitcoin Investment Trust is a Grantor Trust, a publicly traded trust (PTT). “Treatment of an interest in a grantor trust holding crypto assets means that you have to look through the trust envelope to the underlying positions,” says New York tax attorney Roger Lorence JD.

It’s similar to other PTTs; like the SPDR Gold Shares (NYSEArca: GLD) with long-term capital gains using the collectibles tax rate applicable to precious metals. With the look-through rule, the cryptocurrency investment trusts are subject to taxation as intangible property.

Excess business losses
The new tax law limits current year business losses to $500,000 (married) and $250,000 (other taxpayers) starting in 2018. The excess business loss carries forward as a net operating loss (NOL). In 2017, there wasn’t a limit, and taxpayers could carryback NOLs two tax years and/or forward 20 years. Section 475 losses often generated immediate tax refunds from NOL carryback returns. At least NOL carryforwards are better than capital loss carryovers.

Several coin traders face a tax trap
They had massive capital gains in 2017 and had not yet paid the IRS and state their 2017 taxes owed. Meanwhile, in Q1 2018, their coin portfolios significantly declined in value, and they incurred substantial trading losses. They now face a significant tax problem: They need to sell cryptocurrencies to raise cash to pay their 2017 tax liabilities due by April 17, 2018. That would leave many of them with little coin left to continue trading. They may choose to file their automatic extensions without tax payment or a small payment and incur a late-payment penalty of 0.5% per month by the extension due date of Oct. 15, 2018. They are banking on coin prices increasing and thereby generating trading gains by Oct. 15. It reminds me of trading on margin; only the bank (in this case, tax authorities) cannot force a sale now. (See Tax Extensions: 12 Tips To Save You Money.)

A Section 475 election is not a savior in this situation: Section 475 turns 2018 capital losses into ordinary losses on TTS positions, but the IRS no longer allows 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.

Mining inventory vs. capital assets
When a miner receives coin, it’s revenue. The net income after mining expenses is ordinary income and self-employment income. If the miner converts that coin from mining inventory to a capital asset, subsequent sales or exchanges of that coin are capital gains and losses, not ordinary income or loss. Most coin accounting programs assume a conversion to capital asset treatment takes place. However, a miner may not intend to convert coin to a capital asset, and instead leave the coin in inventory. A subsequent sale or exchange would then be an ordinary gain or loss as part of the mining business.

How to qualify for trader tax status
Are you unsure if you are eligible for TTS? Here are the GreenTraderTax 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 when the coin exchange breaks down an order into multiple executions.
- Frequency: trade executions on 75% 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: The Endicott 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 don’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. It was when I created GreenTraderTax, urging clients and followers in chat rooms to elect 475 for free tax-loss insurance. When the tech bubble burst in 2000, those that 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 coin traders now.

Darren Neuschwander CPA contributed to this blog post.

 


Cryptocurrency Traders Owe Massive Taxes For 2017

January 1, 2018 | By: Robert A. Green, CPA | Read it on

I consulted dozens of cryptocurrency (coin) traders on taxes in December and confirmed what the media has been reporting: Coin traders made fortunes in 2017. Now that the 2017 tax-filing season is underway, these traders should gather online tax reports if available, use a coin trade accounting program, and review the latest guidance on tax treatment.

Coinbase has a new online tax report
On July 6, 2017, the IRS narrowed its summons against Coinbase, the most substantial U.S.-based coin exchange, to retrieve larger customers’ trades and other transactions to find unreported income. In late-December 2017, Coinbase added tax reporting of capital gains and losses using first in first out (FIFO). This move should undoubtedly please the IRS since there is no 1099-B issuance on coin trades.

Update Feb. 2, 2018: Coinbase issued 2017 Form 1099-Ks to “qualifying customers,” including businesses, and traders, over specific volume thresholds. (See 1099-K Tax Forms). The IRS intended 1099-K for businesses (merchants) to report Payment Card and Third Party Network Transactions. (See Understanding Your Form 1099-K.)

Capital gains and losses
If you invested in cryptocurrencies and sold, exchanged, or spent it in 2017, you have to report a capital gain or loss on each transaction, including coin-to-currency sales, coin-to-coin trades, and purchases of goods or services using a coin. Deduct coin fees and other expenses appropriately.

Some coin deals naturally generate taxable income, including coin-to-currency trades and mining income. For example, Bitcoin sold for U.S. dollars is a noticeable capital gain or loss reportable on Form 8949. Or, when a coin miner receives a coin for his work, he or she naturally recognizes business revenue based on the value of the coin.

Imputed income
The big problem for the IRS is that most other coin transactions are not evident for tax reporting, including coin-to-coin trades, hard forks (chain splits), and using a coin to purchase goods and services. The coin investor should “impute” a sales or exchange transaction to report a capital gain or loss on coin-to-coin trades and using a coin to purchase items. Many coin investors and their accountants overlook or mishandle this reporting and underpay the IRS.

The IRS labels coin “intangible property.” Coin users may call it “digital money,” but it’s not sovereign government-issued money. That’s the critical difference: Each use of money is not a taxable event. Imagine having to report a capital gain or loss every time you purchased an item or asset with cash or a credit card. That would be ridiculous.

Coin-to-currency trades
Most taxpayers comprehend that if they purchased Bitcoin in 2016 for $10,000 and sold in 2017 for $30,000, they should report a capital gain of $20,000 on their 2017 tax return form 8949. A coin position held for one year or less is considered a short-term capital gain, taxed at ordinary tax rates (up to 39.6% for 2017 and 37% for 2018). A coin position held for more than one year is considered a long-term capital gain, 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.

Coin-to-coin trades
Many coin traders actively make coin-to-coin trades like Bitcoin to Ethereum and then Ethereum to Litecoin. Currently, coin investors purchase alt coins using Bitcoin or Ethereum.

Many taxpayers and preparers delay capital gains income on coin-to-coin trades by inappropriately classifying them as Section 1031 “like-kind exchanges,” where they may defer income to the replacement position’s cost basis. While the IRS hasn’t provided guidance on this matter, I 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 reminds me of forex trading between different currency pairs. Various currencies are not like-kind property (i.e., U.S. dollars are not a like-kind property with euros). Each coin has its version of a blockchain, and the network of users has a different purpose for each coin.

I asked coin tax expert Jim Calvin, Partner of Deloitte and author of When (and If) Income is Realized from Bitcoin Chain-Splits, if he thought these trades could qualify for Section 1031 like-kind exchange treatment in 2017 and prior years.

“It is neither a simple nor single factual issue,” he said. “It is not just whether the swapped coins are like-kind property, but also whether all the other requirements of Section 1031 can be met including the use of intermediaries.”

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.

Tax Cuts and Jobs Act and coin traders
Starting in 2018, the Tax Cuts and Jobs Act limits Section 1031 like-kind exchanges to real property, not for sale. Investors may not use it on artwork, collectibles, and other tangible and intangible property, including cryptocurrencies.

The Act introduced Section 199A, a 20% deduction on qualified business income (QBI) in pass-through entities, subject to thresholds, limitations, and haircuts. A trader tax status (TTS) coin trader likely does not qualify for the deduction because he or she has capital gains income, excluded from QBI. This is different from a TTS securities trader who can elect Section 475 MTM ordinary income, which is included in QBI.

Coin hard forks (chain-splits)
The IRS has not provided guidance on hard fork transactions, and tax experts and coin traders debate its tax treatment. Bitcoin had a hard fork in its blockchain on Aug. 1, 2017, dividing into two separate coins: Bitcoin and Bitcoin Cash. Each holder of a Bitcoin unit was entitled to arrange receipt of a unit of Bitcoin Cash. Some Bitcoin holders did not gain immediate access to be able to sell Bitcoin Cash, so they may feel it’s okay to defer income on the fork transaction until they obtain such access, or later sell it. Coinbase did not support Bitcoin Cash when it forked, but it did add it to accounts for rightful holders in late-2017.

It’s reasonable that coin traders should not have to report taxable income on a hard fork until the new coin is time-stamped as a ledger entry, sending the coins to new outputs in the blockchain. Facts and circumstances on hard forks vary widely. An “old fork” could die out if miners collectively switch over to the new blockchain and abandon the old coin. Bitcoin Cash successfully forked from Bitcoin; both trade at higher values today than on the fork date. Hard forks frequently happen, and their initial fair market value varies significantly across coin exchanges.

“Taxable income is realized if the owner of pre-split bitcoin exercises dominion and control over the corresponding chain-split coins, and the income realized will be equal to the value of the chain-split coins at that time,” Calvin said. “Most owners holding Bitcoin on exchanges were unable to control if and when chain-split coins were claimed, the time income was realized, and may still be unaware of the date or value to use.”

I think many Bitcoin Cash holders had dominion and control over the new coin sometime in 2017, and they should recognize ordinary income on receiving it.

Coin trade accounting programs
Coin tax reporting is complex and voluminous. Consider two coin accounting solutions: Bitcoin.Tax and CoinTracking.Info.

The IRS calls for the “specific identification” (SI) accounting method for use on sales of property, including intangible property (coin). IRS regulations for SI require “adequate identification” of lots sold on a contemporaneous basis, and I don’t think most coin traders comply with these rules.  In June 2016, the AICPA asked the IRS if coin traders could use “first in first out” (FIFO) as an alternative solution, which the IRS permits for securities. Unless you comply with SI rules, I suggest using the FIFO accounting method for coin. (See Accounting Method Impacts Crypto Income Taxes.)

Because the IRS labels coin intangible property, wash-sale loss rules likely don’t apply. TTS traders using Section 475 ordinary gain or loss on securities and/or commodities (Section 1256 contracts) may not use Section 475 on a coin since it’s not a security or a commodity in the eyes of the IRS.

How to deduct coin-trading costs
Coin traders pay various transaction costs, fees, and interest expenses in coin and currency. Be sure to convert coin expenses to U.S. dollars at the time spent. It’s critical to distinguish between tax categories — transaction costs, investment expenses, investment interest expenses, and trading business expenses — as they are all handled differently on tax returns.

Transaction fees can be deducted from sales proceeds and then added to cost basis for purchases, so reflect them on net capital gains and losses. These charges include trading costs (approximately 0.25%) paid to a coin exchange and fees paid to miners when transferring coin between addresses to get transactions into the next block.

The new tax law suspends investment expenses for 2018, but you can still deduct them as a miscellaneous itemized deduction for 2017 (if they are more than 2% of AGI). These costs include bank wire transfer fees for transferring currency to a coin exchange; loan or borrow fees paid to a coin exchange; and withdrawal fees paid to a coin exchange for removing money or coin. (It’s essential to separate loan fees vs. margin interest, as they have different tax treatment.)

Investment interest expense can be an itemized deduction, limited to investment income, with the excess carried over to the subsequent tax year. This includes interest on borrowed funds paid in coin to lender/exchange. The new tax law did not change the rules for investment interest expenses.

Trading business expenses are deducted from gross income. If the coin trader qualifies for TTS, investment expenses and investment interest expenses are deducted as business expenses on Schedule C or through an entity.

Miners deduct business expenses against revenues.

Example: Purchasing goods and services with coin
On Jan. 1, 2017, Joe bought 100 Bitcoins at a price of $998 each, for a total cost basis of $99,800. On June 1, 2017, when the price of a Bitcoin unit was $2,452, Joe used a Bitcoin to purchase a computer for $2,452. Without realizing it, Joe triggered a reportable short-term capital gain on his 2017 Form 8949. The sales proceeds are $2,452, representing the fair market value of the Bitcoin he used to purchase the computer. His cost basis for that one Bitcoin unit used is $998, so his net short-term capital gain is $1,454. If Joe uses the computer in his business, he will deduct $2,452 as an expense.

Bottom line
I suggest coin traders calculate capital gains and losses on coin transactions, including coin-to-coin trades made on exchanges, and use the FIFO accounting method. File an extension by the due date of your tax return (April 17, 2018, for individuals), and pay taxes owed for 2017 with the extension. During the additional time (file by Oct. 15, 2018), perhaps the IRS will answer our questions, including which if any coin-to-coin trades may use Section 1031 deferral in 2017. If the IRS allows it, maybe coin traders can still file that way on an original tax return filing. Consult a coin tax expert.

For more information, see Green’s 2018 Cryptocurrency Tax Guide.

If you have any questions, contact us.

 


Cryptocurrency Traders Should Consider These Two Tax Accounting Solutions

October 28, 2017 | By: Robert A. Green, CPA

Shutterstock: Cryptocurrencies

Shutterstock: Cryptocurrencies

Forbes

Smart Tax Accounting Moves For Cryptocurrency Traders

UpdateThe IRS calls for the “specific identification” (SI) accounting method for use on sales of property, including intangible property (coin). IRS regulations for SI require “adequate identification” of lots sold on a contemporaneous basis, and I don’t think most coin traders comply with these rules.  In June 2016, the AICPA asked the IRS if coin traders could use “first in first out” (FIFO) as an alternative solution, which the IRS permits for securities. Unless you comply with SI rules, I suggest using the FIFO accounting method for coin. (See Accounting Method Impacts Crypto Income Taxes.)

If you have multiple cryptocurrency (coin) trades, consider a trade accounting solution dedicated to coin transactions. The program should calculate taxable income and loss based on IRS rules for coin transactions. It should generate capital gains and losses reports to support Form 8949 and “other income” statements. The program needs to account for all coin transactions, including coin-to-currency trades, coin-to-coin trades, receipt of coin in a hard fork or split transaction, purchases of goods or services made with a coin, and mining revenue.

I reviewed two coin accounting solutions that fit the bill: Bitcoin.Tax and CoinTracking.Info. Both programs provide options for different outcomes and in general, stick with the default method to stay clear of potential IRS trouble. (See How Cryptocurrency Investors Can Avert IRS Attack).

Coin exchanges do not provide taxable income reports
Don’t look to your coin exchange for much help with tax reporting. They don’t keep cost-basis information and are unable to give the users online tax reports. A coin is not a “covered security” for Form 1099-B issuance, so coin investors and the IRS don’t receive a 1099-B.

Coin investors are responsible for generating their accounting and tax reports. With uncertainty on tax treatment due to lack of sufficient IRS guidance, many coin traders wind up under-reporting taxable income on coin transactions. In most cases, it may be inadvertent, but sometimes, it’s willful. Using accounting software shows an attempt to be compliant.

The IRS is pursuing coin investors
The IRS served a “John Doe” summons (the worst kind) to the most significant coin exchange, Coinbase, to obtain its customer list for investors and traders with coin transactions worth more than $20,000. The IRS calculated that less than 900 taxpayers reported capital gain or losses on coin transactions in 2015, an alarmingly small number.

With coin prices skyrocketing in 2017, the U.S. Treasury wants tax revenues — its share of the windfall profits. Perhaps this is the reason they labeled coin “intangible property” rather than currency. There wouldn’t be any taxable income or loss on the use of money.

Bitcoin.Tax
I spoke with the owner of Bitcoin.Tax (BT), Colin Mackie, who described his program to me in detail. Here’s what I learned.

“Most coin exchanges allow a download of account history as a CSV file, and then BT imports it,” he said. “BT also has an API solution that works with some coin exchanges like Coinbase and Gemini, to download directly into BT.”

Mackie said the program produces various downloads for capital gains, such as Form 8949 PDFs, 8949 attachable statement, TurboTax import, TaxACT import, and plain CSV.

“For income, it’s a summary of income and mining per coin as a CSV,” he said. “For Section 1031 like-kind exchanges, it’s a statement of the appropriate lines from the Form 8824, one row per trade.”

The BT default method is to report capital gains and losses on coin-to-coin trades like trading Bitcoin for Ethereum. I suggest our clients use this default treatment to be compliant with IRS rules. The program offers an option to defer income and loss on all coin-to-coin trades by treating those trades as Section 1031 like-kind exchanges. If you select the like-kind exchange option, the BT program delays all taxable income or loss on these trades for the entire year until the user sells the coin for currency. Mackie said some accountants requested this option, but I strongly advise our clients against it. (See Cryptocurrency Traders Risk IRS Trouble With Like-Kind Exchanges.)

Mackie recommends BT users to pay careful attention to hard fork transactions, such as when Bitcoin distributed Bitcoin Cash.

“The coin exchange shows an addition to coin balances for the hard fork distribution, but some don’t include the new coin received in trade activity,” he said. “Sometimes BT picks it up automatically. Otherwise, it requires the user to add the new coin manually. The user can enter the new coin in as income using the daily price on the fork date. But, users also have the option to enter zero for cost basis.”

Sometimes a user doesn’t get a constructive receipt of the new coin, or the new coin doesn’t have a trading price on the day received. Report it as taxable income when accepted if you can determine it’s value. (See How To Report Bitcoin Cash And Avoid IRS Trouble.) BT offers a wide selection of accounting methods, which it calls basis methods, and I am not sure all of them will pass muster with the IRS. BT offers FIFO, LIFO, average cost, and specific identification.

Mackie says the specific identification method “uses strategies, so the user may select the lowest cost, highest cost, or closest cost, where the program finds the best match to minimize capital gains.” That sounds like too much cherry picking after year-end. I think users should use acceptable accounting methods and select them in writing before the year commences.

I suggest our clients use FIFO to stay out of harm’s way with the IRS. This program feature of greater choice of basis method naturally leads to more income deferral and that will attract more IRS attention.

All that being said, I think BT is an inexpensive accounting solution that can work well for American taxpayers, provided they stay clear of the non-compliant options to defer income. Be sure that the program captures all transactions from the coin exchange.

BT is free up to 100 transactions, and it charges $19.95 per year when users exceed 100 entries.

CoinTracking.Info
CoinTracking.Info is another accounting solution to consider. I spoke with CoinTracker founder and CEO Dario Kachel to learn more about this program. According to Kachel, CoinTracking is the only service with current and historical prices for all 4,878 coins on the market.

RG: Does CoinTracking (CT) generate a capital gains and losses report for American coin investors in compliance with U.S. tax law?

DK: Yes, it does. CoinTracking creates U.S. compliant tax reports such as Capital Gains And Losses on Form 8949, Other Income Reports, Gift and Donation Reports, Lost and Stolen Reports, and Closing Position. Reports can be exported in many formats like Excel, CSV, PDF and even in standard forms like Form 8949, Statement for the IRS, TaxACT, and TurboTax.

RG: Does CT account for all coin transactions, including coin-to-currency trades, coin-to-coin trades, receipt of coin in a hard fork or split transactions, and each time a coin investor purchases goods or services using a coin?

DK: Yes. We support all your mentioned transactions, which is necessary for a correct capital gains report. Also, we handle mined coins, income (e.g., a salary in cryptos), gifts, donations, and lost or stolen coins.

RG: On coin-to-coin trades, like trading Bitcoin for Ethereum, does CoinTracking report a capital gain on the imputed sale of Bitcoin?

DK: Yes it does. All coin-to-coin trades will be calculated based on the cost basis and the proceeds value of the cryptos at the time of the transaction converted in USD or any other FIAT currency.

RG: On coin-to-coin trades, does CT offer the user an option to use a “like-kind-exchange” to defer the capital gains income?

DK: The option for like-kind calculations on CoinTracking is already in progress, and we will release it in December 2017. But as you said, coin investors do not qualify for like-kind exchanges, and there are no other countries officially supporting like-kind calculations (that we know of at this moment).

RG: For coin forks or splits, does CT account for the receipt of the new coin and report its fair market value or initial trading price as income? Does the program report other income or capital gains income?

DK: There are two ways (for our program) to calculate forked coins. The easy way is to figure them with their fair market value. The other way is to set the cost basis of both coins on the date of the fork depending on the coin distribution. For example, the BTC/BCH split was a 90:10 split. This would mean, that all your new BCH coins would receive a cost basis of 10% of your BTC cost basis.

RG: In How To Report Bitcoin Cash And Avoid IRS Trouble, I suggest two options, too.

RG: Do you give the user the choice of accounting method after-the-fact, so they cherry pick which is best for them in a given tax year? (We frown upon that practice as pointed out in my last blog post, How Cryptocurrency Investors Can Avert IRS Attack.)

DK: Yes, users can change the accounting method as often as they like. We also provide an instant gain calculator, where users can estimate their gain/loss and tax even prior the sale of assets.

CT’s Website states that it offers the various accounting methods including FIFO, LIFO, HIFO, and LOFO.

CT is free to use for up to 200 transactions, and it charges $325 “for lifetime use,” when users exceed 200 entries. “CT also offers more imports than other providers, margin trades, lending and borrowed coins,” says Kachel.

Coin investors and traders face a minefield of IRS trouble on a wide selection of tax accounting issues. Non-compliance is rampant, and the IRS is on the case. Put your best foot forward by using one of these accounting solutions and don’t use the features that can get you into trouble like like-kind exchanges.

If you have questions, please contact us or another expert in coin taxation.


How Cryptocurrency Investors Can Avert IRS Attack

| By: Robert A. Green, CPA

ShutterstockCryptoCoins

Shutterstock

Forbes

Read it on Forbes.com

If you invested in cryptocurrency (coin) and spent some in 2017, it likely triggered a capital gain, loss, or other income, which you should report on your tax return. There is taxable income or loss on all coin transactions, including coin-to-currency trades, coin-to-coin trades, receipt of coin in a hard fork or split transaction, purchases of goods or services using a coin, and mining income. In this post, I show you how to capture the proper income amount on all coin transactions.

Capital gains and losses
Some coin deals naturally generate taxable income, including coin-to-currency trades and mining income. For example, Bitcoin sold for U.S. dollars is a noticeable capital gain or loss reportable on Form 8949. Or, when a coin miner receives a coin for his work, he naturally recognizes revenue based on the value of the coin he received.

Imputed income
The big problem for the IRS is that most other coin transactions are not evident for tax reporting, including coin-to-coin trades, hard fork transactions, and using a coin to purchase goods and services. The coin investor must “impute” a sales transaction to report a capital gain or loss on coin-to-coin trades and using a coin for purchases of items. Many coin investors and their accountants overlook or mishandle this reporting and underpay the IRS.

Coin is intangible property, not money
Overlooked income has to do with the fact that the IRS labeled coin “intangible property.” Coin users may call it “digital money,” but it’s not money. That’s the critical difference: Each use of money is not a taxable event. Imagine having to report a capital gain or loss every time you purchased an item or asset with cash or a credit card. That would be ridiculous.

Coin-to-currency sales are capital gains and losses
Most taxpayers comprehend that if they purchased Bitcoin in 2016 for $10,000 and sold all of it in 2017 for $30,000, they should report a capital gain of $20,000 on their 2017 tax return form 8949. If the investor held the coin position for one year or less, it’s considered a short-term capital gain taxed at ordinary tax rates (up to 39.6% for 2017). If the position was held for more than one year, the long-term capital gain rate (up to 20% for 2017) applies.

Coin-to-coin trades don’t qualify for deferral of income
Many taxpayers and preparers delay capital gains income on coin-to-coin trades by inappropriately classifying them as a Section 1031 “like-kind exchange,” where they may defer income to the replacement position’s cost basis.

I do not think coin-to-coin trades qualify for Section 1031 transactions as they fail the two primary requirements. First, Bitcoin does not qualify as like-kind property with another coin. Second, coin-to-coin trades primarily executed on exchanges are not “direct two-party exchanges” or “multi-party exchanges using a qualified intermediary.” (See Cryptocurrency Traders Risk IRS Trouble With Like-Kind Exchanges.)

Coin splits in hard forks are taxable income
Bitcoin had a hard fork in its blockchain on Aug. 1, 2017, dividing into two separate coins, Bitcoin vs. Bitcoin Cash. Each holder of a Bitcoin unit was entitled to arrange receipt of a unit of Bitcoin Cash.

Some Bitcoin holders did not gain immediate access to be able to sell Bitcoin Cash, so they may feel it’s okay to defer income on the fork transaction until they gain such access. For example, the most significant U.S.-based coin exchange, Coinbase, did not initially support Bitcoin Cash. Before the fork date, Coinbase informed its customers how to arrange receipt of Bitcoin Cash outside of Coinbase. For this reason, the IRS could argue the holder did, in fact, have “constructive receipt of income.”

A Wall Street Journal article, Bitcoin’s Civil War: What You Need to Know, stated the initial fair market value of Bitcoin Cash on Aug. 1, 2017, was $266 per unit. Taxpayers should report $266 per unit or another price that they established, as “Other Income” or as a capital gain on Form 8949. (See How To Report Bitcoin Cash And Avoid IRS Trouble.)

Not every hard fork coin transaction should be treated the same. A very successful coin trader told me it would be more equitable to value new coin received in hard fork transactions with zero cost basis. He pointed out that hard forks are uncontrollable, contentious and they frequently happen, that their initial fair market value varies significantly across coin exchanges, the new coin may not even trade for several days, and that each new coin acts differently with the original coin. For these reasons, he said it’s nearly impossible to establish a balanced formula and value for reporting income on the new coin. Even Bitcoin Cash had a wide-ranging initial trading price on exchanges. (See Blockchain Orphaned Blocks.)

On Oct. 24, 2017, Bitcoin had another hard fork, splitting off Bitcoin Gold. There are more than 4,000 coins; many were created in hard fork transactions.

Example: Purchasing goods and services with coin
On Jan. 1, 2017, Joe bought 100 Bitcoins at a price of $998 each, for a total cost basis of $99,800. On June 1, 2017, when the price of a Bitcoin unit was $2,452, Joe used one Bitcoin to purchase a new computer for an invoice price of $2,452.

Without realizing it, Joe triggered a reportable short-term capital gain on his 2017 Form 8949. The sales proceeds are $2,452, representing the fair market value of the one bitcoin he used to purchase the computer. His cost basis for that one Bitcoin unit used is $998, so his net short-term capital gain is $1,454. If Joe uses the computer in his business, he will deduct $2,452 as an expense.

The IRS is taking action against coin exchanges and investors
The IRS was late in recognizing a coin “tax gap,” and it recently commenced an aggressive campaign to catch coin investors with under-reported income.

The IRS successfully served a John Doe summons (the roughest kind) on Coinbase, and we are awaiting the results of its investigation. You should respect the tax rules for all types of coin transactions to avoid an IRS exam, which could lead to an assessment of back taxes, interest expenses, and penalties. Accuracy-related penalties include a negligence penalty of 20% and a substantial understatement penalty of 20% if you understate your income by 10% or more.

In March 2014, the IRS issued long-awaited guidance (IRS Notice 2014-21) declaring coin “intangible property” and addressing some other tax questions. But, many issues remain uncertain including whether coin-to-coin trades may qualify for a Section 1031 like-kind exchange, how and when to report hard fork coin transactions, how and when to select permissible accounting methods, whether wash sale losses on securities apply to coin, and more.

We cannot hold tax return filings waiting for new IRS guidance, which may not come at all.  Our position is that coin traders cannot use Section 1031 on coin-to-coin trades executed on coin exchanges. Hard fork income is often taxable income when the new coin is received. Section 1091 wash sale loss rules and Section 475 MTM do not apply to coin because it’s not a security. Coin traders should select a permissible accounting method in advance of the year or contemporaneously with the trade — not after the fact.

In my next post, Coin Traders Should Consider These Two Tax Accounting Solutions, I discuss coin accounting solutions and review two leading programs.

If you have questions, please contact us or another expert in coin taxation.

Darren Neuschwander, CPA contributed to this blog post. 

 


Cryptocurrency Traders Risk IRS Trouble With Like-Kind Exchanges

August 13, 2017 | By: Robert A. Green, CPA

shutterstock_653153323

Clash of Bitcoin and Ethereum coins.

ForbesSmall

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.)

Darren Neuschwander, CPA and Deborah King, CPA contributed to this blog post. 


How To Report Bitcoin Cash And Avoid IRS Trouble

August 2, 2017 | By: Robert A. Green, CPA

Forbes

Read it on Forbes.

In light of the Aug. 1 split of Bitcoin into two separate cryptocurrencies, Bitcoin and Bitcoin Cash, many questions remain. While the IRS has issued guidance on cryptocurrency — labeling it an “intangible asset” for investors subject to capital gains and loss treatment using the realization method — it has not issued guidance on cryptocurrency split or “fork” transactions. There are thousands of cryptocurrencies, and many formed in this type of division in the blockchain.

Tax reporting for the receipt of Bitcoin Cash
The initial market price of Bitcoin Cash was $266 per unit, which was 9.5% of the comparable Bitcoin unit price at that time of $2,801. Bitcoin holders were distributed one unit of Bitcoin Cash for each unit of Bitcoin, a separate financial instrument with a liquid market value. In the eyes of the IRS, that’s taxable income. (An alternative name for Bitcoin Cash is BCash.)

Bitcoin holders should report the receipt of Bitcoin Cash on their 2017 income tax returns. It does not qualify as dividend income on Schedule B since a cryptocurrency is not a security. It’s also not considered interest income on a debt instrument or bank deposit. I suggest reporting the value received as “Other Income” on line 21 of Form 1040 —a catchall category for income that does not fit into a standard category.

Some taxpayers might choose to use Form 8949 (Sales and Other Dispositions of Capital Assets) instead. The taxpayer reports the $266 value of Bitcoin Cash as proceeds and 9.5% of Bitcoin cost basis as Bitcoin Cash cost basis. The initial value of Bitcoin Cash was 9.5% of the Bitcoin price at that time. This alternative treatment reduces taxable income by the cost basis amount. Another benefit is capital gains use up capital loss carryovers. I question whether this method would pass muster with the IRS — Bitcoin did not decline in value by a material amount after the split, and that undermines the use of this treatment.

Constructive receipt of income
Some Bitcoin holders mishandled or skipped arranging access to Bitcoin Cash, or their exchange does not support Bitcoin Cash, making retrieval difficult or impossible after Aug. 1, 2017. These taxpayers may believe they don’t have to report the Bitcoin Cash as taxable income since they don’t currently have access to it. While that seems reasonable, the IRS could apply the constructive receipt of income doctrine to argue the Bitcoin holder had access to Bitcoin Cash but turned his or her back on receiving it. Kelly Phillips Erb of Forbes goes into more detail in her article, Bitcoin Shift Could Cause Tax Headaches For Some Users).

Tax reporting for the sale of Bitcoin Cash
If you sold your Bitcoin Cash, you need to use capital gains treatment on Form 8949. For proceeds, enter the selling price. For cost basis, enter the $266 Bitcoin Cash value received per unit as you previously reported it as Other Income on line 21 of your 2017 Form 1040. The holding period for these units of Bitcoin Cash started on Aug. 1, 2017.

A cryptocurrency split is not a tax-free exchange
Taxpayers may feel a cryptocurrency split such as Bitcoin Cash qualifies as a tax-free exchange. I don’t think it does because cryptocurrencies are not securities, where tax-free splits are possible.

“Receipt of new Bitcoin Cash assets is a taxable event,” said tax attorney Roger D. Lorence. “Corporate taxation concepts on distributions to shareholders, dividends, spinoffs, split-offs, corporate reorganization nonrecognition events under Section 368 and allied rules, are all not applicable, as cryptocurrency is not a security. The new Bitcoin Cash assets are substantially different economically from the old Bitcoin assets.”

Lorence said the Supreme Court decision in Cottage Savings supports the view that the two classes of Bitcoin assets are not identical and therefore the transfer of the assets is considered a new class for which no nonrecognition provision of the code applies.

The IRS goes after cryptocurrency investors
Many cryptocurrency investors made a fortune the past several years selling high-flying Bitcoin and other cryptocurrencies for cash. Unfortunately, far too many of them did not report this taxable income to the IRS. Some cryptocurrency investors used Section 1031 like-kind exchange tax law to defer taxation, but that may be inappropriate (stay tuned for a blog post on that soon). Some cryptocurrency exchanges issued Form 1099-K, Payment Card and Third Party Network Transactions. The IRS feels they are insufficiently informed, so they are taking action.

Bitcoin rose in price from $13 in 2009 to more than $3,000 on June 11, 2017, and on Aug. 1, 2017, its market cap was $44 billion. Ethereum had a market cap of $21 billion. Bitcoin Cash skyrocketed overnight to a market cap of $12 billion on Aug. 2, 2017. The IRS figures hundreds of thousands of American residents did not report income from sales or exchanges of cryptocurrency and they might be able to collect several billion dollars in back taxes, penalties, and interest.

The IRS recently summoned Coinbase, one of the largest cryptocurrency exchanges, to turn over its customer lists. It later agreed to narrow the scope of the list to people with cryptocurrency transactions worth over $20,000 without a Form 1099-K. (Read IRS Blinks in Bitcoin Probe, Exempts Coinbase Transactions Under $20,000.)

Tax treatment for sales of cryptocurrencies
The IRS was slow to issue guidance for cryptocurrencies. It finally declared cryptocurrencies an “intangible asset,” not a sovereign currency, and sales and exchanges are subject to capital gain or loss treatment for investors and traders, using the realization method. (Read If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)

There is tax controversy brewing with cryptocurrency investors, which means tax exams will escalate. Don’t be greedy: Pay your capital gains taxes on windfall income and amend tax returns to report capital gains before the IRS catches up with you.

Darren Neuschwander CPA, Adam Manning CPA and tax attorneys Roger D. Lorence and Mark M. Feldman contributed to this blog post.


If You Traded Bitcoin, You Should Report Capital Gains To The IRS

February 16, 2017 | By: Robert A. Green, CPA

Forbes

If You Traded Bitcoin, You Should Report Capital Gains To The IRS

The IRS considers cryptocurrencies, including Bitcoin, to be “intangible property.” Investors and traders holding cryptocurrency as a capital asset should use capital gain or loss tax treatment on sales and exchanges, with the realization method. For example, if you buy Bitcoins with U.S. dollars and later sell them for U.S. dollars, a capital gain or loss needs to be reported on that transaction. An exchange of one cryptocurrency for another cryptocurrency is a taxable sale transaction, even though U.S. dollars are not involved in the transaction.

Americans also trade Bitcoin or leveraged Bitcoin contracts on Bitcoin exchanges, and they should report realized capital gains and losses on each trade, even if the trader doesn’t convert underlying Bitcoin back into U.S. dollars.

It’s similar to having a foreign-based brokerage account, denominated in a foreign currency (i.e., Euros), where a trader buys and sells European equities held in Euros, and does not convert Euros back to U.S. dollars during the year. Two potential choices for tax reporting: Convert Bitcoin to U.S. dollars on each purchase and sale transaction using the Bitcoin market price that day denominated in U.S. dollars, or perhaps the IRS will allow using Bitcoin as a functional currency, using an average Bitcoin vs. U.S. dollar conversion rate for the tax year.

The CFTC does not permit American retail customers to trade leveraged Bitcoin contracts on unregistered Bitcoin exchanges. (Read my related blog post: If You Want To Trade Bitcoins, First Learn CFTC Rules.)

Whether it’s legal or not under CFTC regulations, the IRS requires American resident taxpayers to report Bitcoin trading income and losses worldwide on U.S. resident tax returns. It doesn’t matter whether you repatriate funds back to the U.S., or not.

IRS guidance on cryptocurrency
In March 2014, the IRS issued long-awaited guidance (IRS Notice 2014-21) labeling cryptocurrency, including Bitcoin, “intangible property.” Investors and traders hold Bitcoin as a capital asset, so it receives capital gain and loss treatment. The AICPA and others have requested further guidance on virtual currency from the IRS. For investors and traders, I have a few unresolved questions below.

Intangible property is not a security, yet it seems logical that several tax rules for investors and traders are similar, whereas a few others are not.

Cryptocurrency is like securities in these cases

  • Use the realization method for sales of cryptocurrency held as a capital asset, which means you defer reporting of the capital gain or loss until closing the position.
  • Don’t use mark-to-market accounting at year-end, which means you don’t report unrealized gains and losses.
  • Use holding period rules to distinguish between short-term vs. long-term (12 months or longer) capital gains and losses. The long-term capital gains rates are lower than short-term rates, taxed as ordinary income.
  • The $3,000 capital loss limitation against other income applies.
  • Report each trade separately on Form 8949 (Sales and Other Dispositions of Capital Assets); we assume the IRS does not permit summary reporting. It’s OK to attach a report from your broker listing an accounting for each cryptocurrency trade.

Cryptocurrency is unlike securities in these cases

  • I don’t think you’ll have to make wash sale loss adjustments since Section 1091 wash sale rules only mention securities, not intangible property. Hopefully, the IRS will clarify this issue.
  • Traders qualifying for trader tax status may not elect Section 475 ordinary gain or loss treatment on cryptocurrency. Section 475 covers securities and commodities, not intangible property.
  • Cryptocurrency is not sovereign currency or forex with Section 988 ordinary gain or loss treatment, or Section 1256(g) foreign currency contract treatment. The IRS and CFTC call cryptocurrency “currency,” but not “foreign currency.”

Onshore and offshore cryptocurrency exchanges do not issue American investors or traders a Form 1099B.

Read my prior blog post: IRS Guidance On Bitcoin Transactions.

Nadex offered Bitcoin binary contracts in 2016
The North American Derivatives Exchange, Inc. (Nadex), a U.S.-based CFTC-regulated derivatives exchange, offered Bitcoin binary contracts for part of 2016. On Dec. 16, 2016, Nadex filed a Self-Certification to Delist Bitcoin.

Over the past several years, Nadex issued Americans a Form 1099B for Section 1256 contracts. That’s an advantageous tax treatment with lower 60/40 tax rates, and I doubt whether it’s correct to use Section 1256 tax treatment for Bitcoin binary contracts. (Read Tax Treatment For Nadex Binary Options.)

Bitcoin and foreign bank account reporting
U.S. residents with a foreign bank, brokerage, investment and another type of account (including retirement and insurance in some cases) who meet reporting requirements must e-file FinCEN Form 114, Report of Foreign Bank and Financial Account. If your foreign bank and financial institution accounts combined are under $10,000 for the entire tax year, you fall under the threshold for filing FinCEN Form 114.

The IRS allowed taxpayers to exclude Bitcoin from 2013 foreign bank account filings. It’s not clear if the IRS continues to allow an exclusion of Bitcoin, or Bitcoin derivative contracts, on current year FinCEN 114 filings. Suppose you have Bitcoin or Bitcoin derivative contracts held at a foreign Bitcoin exchange. When in doubt, and considering significant penalties for non-compliance, it’s probably wise to include these Bitcoin accounts on FinCEN 114. (Read Bitcoin Is Not Reported On 2013 FBARs.)

For another update on cryptocurrency tax treatment, read Taxation of Virtual Currency, Jan. 16, 2017, Bloomberg, by Elizabeth R. Carter.


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