The massive tax bust of crypto owners has begun with the IRS mailing 10,000 letters to crypto account owners. These letters educate crypto account holders about the rules and tell taxpayers to review their tax reporting for crypto transactions to be sure they reported income correctly. If necessary, taxpayers should file amended tax returns and or late returns. These tax returns should be marked with the corresponding letter type (i.e., Letter 6173, 6174 or 6174-A) and mailed to a particular IRS address. In other words, these tax filings won’t be a needle in the haystack and the IRS will take a close look. Many audits may follow.

IRS Letter 6173

“We have information that you have or had one or more accounts containing virtual currency and may not have met your U.S. tax filing and reporting requirements for transactions involving virtual currency, which include cryptocurrency and non-crypto virtual currencies.”

The IRS might know there is unreported income based on tax information obtained through enforcement actions, which include the summons against U.S. Coinbase customers. You received the letter because you didn’t file a tax return, which should have included virtual currency transactions. Alternatively, you filed a return but did not report virtual currency transactions. You must reply to this tax notice by submitting a correct late tax return or an amended return. If you disagree with the IRS, the letter requires a full explanation with a signed statement declared under penalties of perjury.

Letter 6173 is a severe tax notice, and you should not dig yourself into a bigger hole with an incorrect reply. In some cases, perjury could be a felony. The letter states, “If we don’t hear from you by the “respond by” date we may refer your tax account for examination.”

I wonder how the IRS will conduct its audits of virtual currency transactions. They will need a list of all coin exchanges and private wallets and probably have to use trade accounting software in the same way a taxpayer would.

IRS Letter 6174

“We have information that you have or had one or more accounts containing virtual currency but may not know the requirements for reporting transactions involving virtual currency, which include cryptocurrency and non-crypto virtual currencies. After reviewing the (educational) information below, if you believe you didn’t accurately report your virtual currency transactions on a federal income tax return, you should file amended returns or delinquent returns if you didn’t file a return for one or more taxable years.”

The key phrase is that the taxpayer “may not know” crypto tax treatment. It sounds like the IRS does not have sufficient information indicating unreported income. Letter 6174 is an “educational letter,” and it states, “you do not need to respond to this letter.” If you received this tax notice, then you should review your crypto tax reporting and consider filing an amended tax return, if appropriate. Consider the IRS advice a warning shot across your bow.

Letter 6174-A

“We have information that you have or had one or more accounts containing virtual currency but may not have properly reported your transactions involving virtual currency, which include cryptocurrency and non-crypto virtual currencies. After reviewing the information below, if you believe you didn’t accurately report your virtual currency transactions on a federal income tax return, you should file amended returns or delinquent returns if you didn’t file a return for one or more taxable years. You do not need to respond to this letter.”

The critical phrase is “may not have properly reported.” That’s different from Letter 6173, which states “may not have met” your tax requirements. Letter 6174-A implies the taxpayer reported crypto transactions, but perhaps not in the proper way. For example, maybe the taxpayer used Schedule C (business income) instead of Form 8949 (capital gains). Perhaps they used like-kind exchanges, and the IRS might not allow that. Conversely, Letter 6173 indicates the taxpayer did not report crypto transactions at all.

The IRS has various types of tax information for virtual currency account owners, and it selected the letter that best matched their knowledge base. The IRS is also using third-party services to obtain more tax information. It’s wise to come clean now if you know you have errors in reporting crypto transactions. Historically, taxpayers have performed better in seeking abatement of penalties if they come forward to the IRS before getting busted first.

Civil and criminal prosecution and FBAR reporting
The IRS stressed, “Taxpayers who do not properly report the income tax consequences of virtual currency transactions are, when appropriate, liable for tax, penalties, and interest. In some cases, taxpayers could be subject to criminal prosecution.” The IRS sent mob boss Al Capone to prison for tax evasion, which was less challenging than indicting him for unlawful bootlegging. Learn about accuracy-related penalties and what constitutes reasonable cause for reduction of penalties.

The IRS Virtual Currency Compliance campaign reminds me of IRS initiatives to hunt down hidden offshore bank and brokerage accounts. FATCA legislation forced foreign banks into reporting on U.S. resident accounts. The IRS Offshore Voluntary Disclosure Program (OVDP) helped taxpayers come clean with voluntary reporting. That led to reduced penalties, which otherwise were onerous. Some tax cheats used foreign bank accounts to conceal business income from the IRS. Others protected assets with offshore structures and only did not correctly report portfolio income.

In retrospect, it seems the IRS made a mistake in (unofficially) waiving foreign bank account report FinCEN 114 and Form 8938 for offshore virtual currency accounts. Virtual currency is “property,” which did not meet the requirements for FinCEN 114 and Form 8938 (Statement of Specified Foreign Financial Assets). There are significant penalties for not filing FinCEN 114 (previously known as FBAR) on time with the U.S. Treasury. Once you put Treasury on notice of owning these accounts, it dissuades you from hiding income from the IRS on those same accounts.

Coin-to-coin exchanges
In the educational section of these IRS letters, it states that crypto-to-crypto trades (i.e., Bitcoin for Ether) are taxable capital gains. The letter does not mention Section 1031 or like-kind exchanges being allowed on pre-2018 trades. (The new tax law TCJA restricted like-kind exchanges to real property only, starting in 2018.) Many crypto traders did not report deferred capital gains on coin-to-coin trades. Some may have, but they omitted the required Form 8824.

I’ve questioned whether coin-to-coin trades qualify for like-kind exchange treatment in years before 2018. Different types of virtual currencies might not be eligible as like-kind property, and coin exchanges are not qualified intermediaries. Multi-party like-kind exchanges require both.

Tax information statements and trade accounting
The IRS letters say to report all transactions whether tax information statements (Form 1099) were sent, or not, for crypto accounts held in the U.S., or abroad. Cryptocurrencies are “property,” not a “security,” so it’s not a “covered security” for purposes of 1099-B reporting. Coinbase, the largest U.S. crypto exchange, appeased the IRS during their fight for obtaining taxpayer information, by issuing a Form 1099-K for larger accounts. The IRS intended Form 1099-K for third-party network transactions for merchants; not traders or investors. Only U.S. exchanges might provide 1099-Ks. Coinbase also provided capital gain and loss reports for later years.

Taxpayers should consider using a trade accounting solution or software program to download virtual currency transactions from all coin exchanges and private wallets. Many crypto owners have accounts around the world, and accounting issues are more challenging when trading on margin. The IRS will likely use this same software in an exam.

Additional IRS guidance coming soon
The IRS keeps promising to publish further advice on crypto tax treatment soon. Why did they send 10,000 education letters if they plan to update their education guidance shortly? Perhaps, it would have been better to publish updated guidance before mailing them. This letter campaign seems a bit like a fishing expedition: The IRS wants more tax returns to analyze before it tackles tax treatment issues further.

Additional guidance is expected to address like-kind exchanges; chain splits, permissible accounting methods, wash sales, Section 475, and more. The AICPA issued a letter containing suggested questions and answers. The basics are clear, and the delay in additional guidance is no excuse for non-compliance.

IRS data analytics
The IRS said it would continue to use data analytics, and perhaps other blockchain technology to uncover more non-compliant crypto taxpayers. The IRS successfully used an independent company Chainalysis on recovering tax information from U.S. Coinbase customers. That may have been one of the sources for this first batch of 10,000 account letters.

What tax evaders didn’t initially realize is that virtual currencies may not be an ideal medium of exchange for concealing income and assets from tax authorities. Unlike using cash (dollar bills), blockchain is a distributed ledger which is available to the public. Non-crypto virtual currency may have a private company centralized ledger, but the IRS might be able to get that through a summons, too. AI, blockchain tools, and crypto trade accounting programs will help the IRS bust crypto tax evaders and taxpayers who are honest but misinformed.

Takeaway
This IRS letter campaign is just the beginning of virtual currency enforcement activities to come. You should take this opportunity to get fully educated, review your reporting, and be sure you are tax compliant. Pay tax liabilities and interest expenses, and then seek abatement of penalties when assessed. Some crypto users might try to claim ignorance or argue they received terrible tax advice. Others might assert that the crypto tax rules were too vague and uncertain at the time of filing. Some tax treatment issues are unknown (i.e., like-kind exchanges and hard forks), but the basics are clear. After receiving these education letters, which are warning shots, there are no grounds for continued non-compliance.

Consult a crypto tax expert immediately after receiving any of the above IRS letters. The CPA can reply to Letter 6173 soon and request more time to file amended returns. The 2018 tax return deadlines are coming up on September 15, 2019, for entities, and October 15 for individuals. Plan to work with your CPA after those dates on amended tax return filings.

Breaking news and more resources

IRS IR-2019-132: IRS has begun sending letters to virtual currency owners advising them to pay back taxes, file amended returns; part of agency’s larger efforts. 

WSJ quotes my partner in IRS Sending Warning Letters to More Than 10,000 Cryptocurrency Holders. “When it comes to preparing tax returns involving cryptocurrencies, Darren Neuschwander, a certified public accountant, said many tax preparers are frustrated because the IRS has long promised new guidance on cryptocurrencies that it hasn’t yet released.” “It’s ironic that the IRS is issuing these letters because we’re still waiting to know more rules,” he said.

IRS Sends Out 10,000 Letters to Virtual Currency Investors, Some of Which Demand a Response, By Ed Zollars CPA for Kaplan Financial Education.

Blockchain Analytics Firm Chainalysis Outlines User Data Policy Amid Coinbase Allegations in CoinTelegraph.

The IRS Has Special Software to Find Bitcoin Tax Cheats. Fortune.com

GreenTraderTax cryptocurrency resources:
Tax Center
Blog posts on cryptocurrencies
Green’s 2019 Trader Tax Guide
Trade accounting service for cryptocurrencies

Darren Neuschwander CPA contributed to this blog post.

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.

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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. 

Clash of Bitcoin and Ethereum coins.

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.