Category: Tax Treatment On Financial Products

Tips For Traders: Preparing 2020 Tax Returns, Extensions, and 475 Elections

March 1, 2021 | By: Robert A. Green, CPA | Read it on

March 17, 2021: Tax Day for individuals extended to May 17: Treasury, IRS extend filing and payment deadline. “The Treasury Department and Internal Revenue Service announced today that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. The IRS will be providing formal guidance in the coming days. Individual taxpayers can also postpone federal income tax payments for the 2020 tax year due on April 15, 2021, to May 17, 2021, without penalties and interest, regardless of the amount owed. This relief does not apply to (2021) estimated tax payments that are due on April 15, 2021. The IRS urges taxpayers to check with their state tax agencies for those details.” (IRS Issue Number: IR-2021-59). Intuit: State Tax Deadline Updates. The postponement does not apply to C-Corps, trusts, and estates.

March 29, 2021: The good news is the 475 election is due May 17, 2021, with the 2020 tax return or extension. The IRS issued formal guidance Notice 2021-21, “Relief For Form 1040 Filers Affected By Ongoing Coronavirus Disease 2019 Pandemic.” The IRS notice states, “Finally, elections that are made or required to be made on a timely filed Form 1040 series (or attachment to such form) will be timely made if filed on such form or attachment, as appropriate, on or before May 17, 2021.” The IRS notice also postponed the 2020 IRA and HSA contribution tax deadline to May 17, 2021.

Original post:

Traders use various tax forms as the IRS hasn’t created specialized tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, and business expenses on different forms. It’s often confusing. Which form should forex traders use? Which form is correct for securities traders using the Section 475 MTM method? Can one report trading gains directly on a Schedule C? The different reporting strategies for various types of traders make tax time not so cut-and-dry.

Sole Proprietor Trading Business

Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for active traders who qualify. The first step is to determine eligibility. Our golden rules require four trades per day, close to four days per week, and an average holding period under 31 days. See all the requirements at Trader Tax Status: How To Qualify.

If a trader qualifies for TTS, he can claim some tax breaks after the fact (such as business expense treatment) and elect and set up other benefits (such as Section 475 MTM and employee-benefit plans) on a timely basis. You can assess and claim TTS business expense deductions for all or part of 2020.

Other sole-proprietorship businesses report revenue, cost of goods sold, and expenses on Schedule C. But TTS business traders report only trading business expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation.

Trading Gains and Losses

Sales of securities must be first reported (line by line) on Form 8949 based on the realization method with cost basis adjustments, including wash sale (WS) losses. Form 8949 then feeds into Schedule D short-term capital gains using the ordinary tax rate and long-term capital gains for securities held 12 months using the lower capital gains rate. Capital losses offset capital gains in full, and net capital losses are limited to $3,000 per year against ordinary income (the rest is a capital loss carryover to subsequent years).

Some brokers provide Form 8949 in addition to Form 1099-B. Consider using trade accounting software to calculate WS loss adjustments. See Form 8949 & 1099-B Issues.

TTS traders who use Section 475 MTM accounting on securities report their TTS trades (line by line) on Form 4797 Part II. “MTM” means open positions are marked-to-market at year-end. Form 4797 Part II has business ordinary loss treatment and avoids the capital loss limitation and wash-sale loss adjustments. Form 4797 losses are included in net operating loss (NOL) calculations. Consider using trade accounting software to generate Form 4797 for Section 475 trades. Without wash sale losses, the trader will be departing from the 1099-B and should explain that in a tax return footnote.

Section 1256 contracts (i.e., regulated futures contracts) use MTM accounting and are reported on Form 6781 (unless the TTS trader elected Section 475 for commodities/futures; in that case Form 4797 is used). Section 1256 traders rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss on contracts”). They may simply enter that amount in summary form on Form 6781 Part I. There are no wash-sale losses on 1256 contracts.

If the trader had a significant Section 1256 loss in 2020, she should consider carrying back those losses three tax years but only apply against Section 1256 gains in those years. To obtain this election, check box D labeled “Net section 1256 contracts loss election” on the top of Form 6781. You can make this election with a tax return filed on time, including extensions.

Forex traded in the Interbank market uses Section 988 ordinary gain or loss treatment. Forex traders who don’t qualify for TTS should use line 8 (other income or loss) on 2020 Schedule 1 (Form 1040). TTS forex traders should use Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carryforwards against any type of income, whereas Form 1040’s “other losses” do not. The latter is wasted if the taxpayer has a negative income.

In that case, a contemporaneous forex capital gains election is better on the Section 988 trades. If the taxpayer filed the Section 988 opt-out (capital gains) election, she should use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting. See Forex.

Selling, exchanging, or using cryptocurrency triggers capital gains and losses. The IRS treats cryptocurrencies as intangible property. The realization method applies to short-term vs. long-term capital gains and losses, and there is no WS or 475 on intangible property. Report a capital gain or loss on each transaction, including cryptocurrency-to-currency sales, crypto-to-crypto trades, and purchases of goods or services using crypto. Answer the IRS question about cryptocurrency on the 2020 Form 1040 page 1 up top.

For tax treatment on options, ETFs, ETNs, precious metals, foreign futures, and swaps, see Tax Treatment On Financial Products.

Business Expenses on Schedule C

TTS allows a trader to add a Schedule C to deduct business expenses, including these items:

“Tangible personal property” up to $2,500 per item for equipment and furniture.
Section 179 (100%) depreciation on fixed assets. Otherwise, bonus and regular depreciation.
Amortization of start-up costs (Section 195), organization costs (Section 248), and software.
Education expenses paid and courses taken after the commencement of TTS. Otherwise, pre-business education may not be deductible. (Alternatively, include pre-business education in Section 195 start-up costs.)
Subscriptions, scanners, publications, market data, professional services, chat rooms, mentors, coaches, supplies, phone, travel, seminars, conferences, assistants, and consultants.
Home-office expenses for the business portion of the home.
Margin interest expenses.
Stock-borrow fees for short-sellers.
Internal-use software for self-created automated trading systems.

Home office (HO) expenses are first reported on Form 8829. HO is one of the most significant tax deductions for traders. It requires trading gains to unlock most of the deduction; mortgage interest and real estate tax portions of HO do not require income.

When commencing TTS, look back six months to capitalize Section 195 start-up costs, including trading education expenses. The trader can expense (amortize) up to $5,000 in the first year and the balance over 15 years.

Make Schedule C Look Better

The IRS may view a trading business’s Schedule C as unprofitable even if it has significant net trading gains on other forms and is profitable after expenses.

To mitigate this red flag, transfer a portion of business trading gains to Schedule C “Other Income” (not revenue) to zero the expenses out but not show a net profit. Showing a profit could cause the IRS to inquire about self-employment (SE) tax on self-employment income (SEI). Trading expenses reduce SEI, but trading gains and losses are not SEI. Learn how to do this transfer strategy in Green’s 2021 Trader Tax Guide.

Section 475 MTM Accounting

Only TTS traders can elect and use Section 475, not investors. Section 475 trades are exempt from WS loss adjustments on securities. Section 475 ordinary losses are also not subject to the $3,000 capital loss limitation against ordinary income. Section 475 losses and TTS expenses contribute to net operating losses (NOLs). Hence our phrase “tax loss insurance.”

We usually recommend a Section 475 election on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts (commodities).

Profitable traders might also benefit from Section 475. TCJA introduced a 20% deduction on qualified business income (QBI) in pass-through businesses, and TTS traders with 475 elections are eligible for the deduction. QBI includes Section 475 income less TTS expenses. However, QBI excludes capital gains and other portfolio income. TTS traders are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The 2020 taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Use Form 8995 or Form 8995-A for QBI deductions.

Section 475 Election Procedures

To obtain Section 475 as an individual, you must file a 2021 Section 475 election statement with your 2020 tax return or extension due by April 15, 2021. Existing partnerships and S-Corps must file a Section 475 election statement by March 15, 2021.

“New taxpayers” like new entities file an internal Section 475 MTM election resolution within 75 days of inception.

Traders who filed a 475 election for 2020 on time (by July 15, 2020, for individuals) must complete the process by sending a Form 3115 with the 2020 tax return and a duplicate to the national office.

Learn more about Section 475, the pros, cons, and nuances in Green’s 2021 Trader Tax Guide. The guide includes the election statement to use with your filing.

Tax Extensions

The 2020 income tax returns for individuals are due by April 15, 2021 — however, most active traders aren’t ready to file a complete tax return by then. Some brokers issue corrected 1099-Bs right up to the deadline or even beyond. Many partnerships and S-Corps file extensions by March 15, 2021, and don’t issue final Schedule K-1s to investors until after April 15.

The excellent news is traders don’t have to rush the completion of their tax returns by April 15. They may want to consider sending a one-page automatic extension along with payment of taxes owed to the IRS and state.

The IRS postponed the April 15, 2021 tax deadline until June 15, 2021, for residents of Texas, Oklahoma, and Louisiana, after a federal disaster declaration in February 2021 due to winter storms. This postponement also applies to the Section 475 election. The delay includes various 2020 business returns due on March 15 like partnerships and S-Corps.

Traders can request an automatic six-month extension on Form 4868 to file their federal income tax return by Oct. 15, 2021. States also provide tax extensions, with some states accepting the federal election; however, if the taxpayer owes state taxes, a state tax voucher/extension form is required.

The Form 4868 instructions point out how easy it is to get this automatic extension — no reason is required. It’s an extension of time to file a complete tax return, not an extension of time to pay taxes owed. The taxpayer should estimate and report what he thinks he owes for 2020 based on his received tax information.

See how the IRS assesses late-filing penalties and late-payment penalties on page two of Form 4868. If a taxpayer cannot pay the taxes owed, he should estimate the balance due by April 15 and report it on the extension.

Even if a taxpayer cannot pay the balance due, he should at least file Form 4868 by April 15, 2021. Merely filing the extension will avoid the late-filing penalties of 5% per month up to 25%, which are 10 times higher than the late-payment penalty of 0.5% per month up to 25%. The IRS charges interest, too.

Many traders made massive trading gains in 2020 with an explosion of new pandemic-fueled traders and market volatility. Some used the estimated tax payment “safe harbor” exception to cover their 2019 tax liability with a Q4 2020 estimated tax payment made by Jan. 15, 2021. They plan to pay the balance of taxes owed by April 15, 2021. They should consider setting aside and protecting those tax payments. See Traders Should Focus On Q4 Estimated Taxes Due January 15.

Some traders will risk those 2020 tax payments in the markets right up to the deadline, and they should be careful not to lose them because that will cause significant tax trouble with the IRS and state.

Partnerships and S-Corps

The 2020 partnership and S-Corp tax extensions are due March 15, 2021. They are easy to prepare since they pass income and loss to the owner, usually an individual. Generally, pass-through entities are tax-filers but not taxpayers.

S-Corps and partnerships use Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns). Extensions give six additional months to file a federal tax return — by Sept. 15, 2021.

Your must file the partnership or S-Corp extension on time. Otherwise, late-filing penalties apply $210 per month per owner up to 12 months. See the Form 1065 and 1120S instructions for further details about penalties.

Some states require a state extension, whereas others accept a federal extension. Some states have S-Corp franchise taxes, excise taxes, minimum taxes, and payments usually due to the extensions by March 15. LLCs filing as partnerships may have minimum taxes or annual reports due to the extension by March 15. States assess penalties and interest, often based on payments due.

Recent Tax Law Changes

The 2017 Tax Cuts And Jobs Act (TCJA) introduced an “excess business loss” limitation: $500,000 married and $250,000 other taxpayers for 2018, and it’s indexed for inflation each year. Business losses exceeding the EBL limitation are a NOL carryforward. TCJA also suspended NOL carrybacks, allowing NOL carryforwards with 80% limits against subsequent year’s taxable income. The rest carries forward indefinitely.

The 2020 CARES Act provided temporary tax relief: It suspended TCJA’s EBL rules for 2018 through 2020 and allowed five-year NOL carrybacks for 2018, 2019, and 2020. TCJA EBL and NOL rules apply again in 2021.

For other recent tax law changes that impact traders, see TCJA, CARES Act, and Emergency $900 Billion Pandemic Relief.

We expect tax legislation in 2021 that impacts traders, so stay tuned to our blog post for updates.

Takeaway

Traders should focus on the big picture of filing a 2020 automatic extension by the April 15, 2021 deadline. With or without sufficient payment of taxes, filing the extension avoids the late-filing penalty of 5% per month, assessed on the tax balance due. Try to pay 90% of the tax liability to avoid the late-payment penalty of 0.5% per month. Traders unsure of TTS qualification can leave out Schedule C trading expenses from the tax liability calculations used for the extension filing and settle that issue before filing the complete tax return later. The most important issue might be a 2021 Section 475 election due with the 2020 extension by April 15, 2021, for individuals, and March 15, 2021, for partnerships and S-Corps. Overpaying the extension payment is wise for profitable traders to apply the overpayment credit towards 2021 quarterly estimated taxes. It also leaves a cushion on 2020 taxes.

What You Trade Can Make A World Of Tax Difference

September 29, 2019 | By: Robert A. Green, CPA | Read it on

There’s a bevy of financial products to trade with a wide assortment of tax treatment. Traders have access to U.S. and international equities, futures and other Section 1256 contracts, options, ETFs, ETNs, forex, precious metals, foreign futures, cryptocurrencies, and swap contracts. Broker-issued Form 1099-Bs might not provide the best available tax treatment, and in some cases, there are no 1099s issued.

Securities
Securities traders have ordinary tax rates on short-term capital gains, wash sale loss adjustments, capital-loss limitations, and accounting challenges.

Securities include:
– U.S. and international equities (stocks)
– U.S. and foreign equity (stock) options
– narrow-based indexes (an index made up of nine or fewer securities)
– options on narrow-based indexes
– securities ETFs structured as registered investment companies (RIC)
– options on securities ETF RICs
– commodities ETFs structured as publicly traded partnerships (PTP)
– volatility ETNs, structured as debt instruments
– bonds
– mutual funds
– single-stock futures

Securities don’t include:
– Section 1256 contracts
– precious metals (collectibles)
– ETFs structured as publicly traded trusts (PTT)
– CBOE-listed options on ETF PTPs and ETF PTTs
– CBOE-listed options on ETNs
– volatility ETNs structured as prepaid forward contracts (PFC)
– cryptocurrencies (intangible property)
– forex (spot and forwards contracts)
– swap contracts

The IRS taxes securities transactions when a taxpayer closes an open trade – hence the term “realization method.” Taxpayers can defer capital gains by holding open securities positions at year-end.

With “tax-loss selling,” investors realize losses before year-end. Be careful not to re-enter those positions within 31 days; otherwise, the planned tax loss might defer to 2020 as a wash sale loss adjustment.

Short-term capital gains (STCG) use ordinary tax rates, currently up to 37% for 2019 and 2020. Long-term capital gains (LTCG) rates are significantly lower, and they apply to sales of securities held for 12 months or more. The LTCG rates are 0% for the 10% and 12% ordinary brackets, 15% in the middle brackets, and 20% in the top 37% bracket. (See 2019 Tax Brackets.)

The mark-to-market (MTM) accounting method is different. MTM taxes realized and unrealized capital gains and losses at year-end. Traders eligible for trader tax status (TTS) are entitled to elect Section 475 MTM ordinary gain or loss on securities and or commodities. (See How Traders Get Enormous Tax Deductions, And Investors Do Not.) Section 1256 contracts have MTM by default. (See 1256 contracts below).

Capital losses, including capital loss carryovers, offset capital gains without a limitation. A net capital loss for the year is limited to $3,000 against other income like wages. Capital loss carryovers don’t expire; they are deferred tax assets. If you have excess capital losses, don’t rush to elect Section 475 ordinary income as you need capital gains to use up capital losses. Look at all sources of capital gains, including sales of real property and intangible property. Trading entities and hedge funds can pass capital gains to the owner’s tax return.

Section 1256 Contracts
Section 1256 contracts enjoy lower 60/40 capital gains tax rates, summary tax reporting, and easier mark-to-market accounting.

Section 1256 contracts include:
– U.S. regulated futures contracts (RFCs)
– options on U.S. RFCs
– U.S. broad-based indexes made up of 10 or more underlying securities – also known as stock index futures
– options on U.S. broad-based indexes
– foreign futures if granted Section 1256 treatment in an IRS revenue ruling (see list)
– non-equity options (a catchall)
– CBOE-listed options on commodity ETF publicly traded partnerships (PTP)
– CBOE-listed options on precious metals ETF publicly traded trusts (PTT)
– CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt instruments
– forward forex contracts with the opt-out election into Section 1256(g) on the major pairs, for which futures trade (we make a case for spot forex, too)
– forex OTC options (Wright court)

Section 1256 contracts have lower 60/40 capital gains tax rates: 60% (including day trades) subject to lower long-term capital gains rates, and 40% taxed as short-term capital gains using the ordinary rate. At the maximum tax bracket for 2019 and 2020, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary bracket of 37%. There are significant tax savings throughout the income brackets. The LTCG rate in the lowest two ordinary brackets is 0%. (See our table Section 1256 tax rates vs. ordinary rates.)

Section 1256 contracts are marked-to-market (MTM) daily. For tax purposes, MTM reports both realized activity from throughout the year and unrealized gains and losses on open trading positions at year-end. The 1099-B is one page with summary reporting.

There is a Section 1256 loss carryback election. Rather than use the 1256 loss in the current year, deduct 1256 losses on amended tax return filings, applied against Section 1256 gains only. Form 1045 is better than 1040X. It’s a three-year carryback; unused amounts carry forward. TCJA repealed most NOL carrybacks, so this is the only remaining carryback opportunity for traders. (See Trading Futures & Other Section 1256 Contracts Has Tax Advantages.)

Options
Tax treatment for options is diverse, including simple (outright) and complex trades with multiple legs.

Options taxed as securities:
– equity (stock) options
– options on narrow-based indexes
– options on securities ETFs RIC

Options taxed as 1256 contracts:
– non-equity options (a catchall)
– options on U.S. regulated futures contracts and broad-based indexes
– CBOE-listed options on commodity ETF publicly traded partnerships (PTP)
– CBOE-listed options on precious metals ETF publicly traded trusts (PTT)
– CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt instruments
– forex OTC options (Wright appeals court)

Generally, options listed on a commodities exchange, a qualified board or exchange (QBE), are a 1256 contract unless the reference is a single stock or a narrow-based stock index. A securities ETF RIC is like a stock in this regard.

Three things can happen with outright option trades:

– Trade option (closing transaction).
– The option expires (lapses).
– Exercise the option.

There are special rules for the holding period for long-term capital gains. (See Tax Treatment Can Be Tricky With Options and ETFs.)

Exchange-Traded Funds (ETF)
Securities, commodities, and precious metals ETFs use different structures, and tax treatment varies.

Securities ETFs: Securities ETFs are registered investment companies (RICs). Selling a securities ETF is deemed a sale of a security, calling for short-term and long-term capital gains tax treatment on the realization method. As a security, wash sale loss adjustments or Section 475 apply if elected.

Commodities ETFs: Commodities ETFs use the publicly traded partnership (PTP) structure. PTPs issue annual Schedule K-1s passing through Section 1256 tax treatment on Section 1256 transactions to investors, as well as other taxable items. Selling a commodity ETF is deemed a sale of a security, calling for short-term and long-term capital gains tax treatment using the realization method. It’s a security, so it’s subject to WS losses and a 475 election if elected.

Taxpayers invested in commodities ETFs should adjust cost-basis on Form 8949 (capital gains and losses). That ensures they don’t double count Schedule K-1 pass-through income or loss. Form 1099-B and trade accounting software do not make this adjustment, so you need to make a manual adjustment.

Physically backed precious metals ETFs: They usually choose the publicly traded trust (PTT) structure (also known as a grantor trust). A PTT issues an annual Schedule K-1, passing through tax treatment to the investor, which in this case is the “collectibles” rate on sales of physically-backed precious metals (such as gold bullion). Selling a precious metal ETF is deemed disposition of a precious metal, which is a collectible. For collectibles held over one year (long-term), sales use the “collectibles” rate —capped at 28%. Short-term capital gains use the ordinary rate. Precious metals and ETFs backed by precious metals are not securities, so they are not subject to WS loss adjustments, or Section 475 if elected.

Forex
Forex transactions start off receiving an ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). Ordinary losses are generally better than capital losses, providing the trader has other income to absorb the loss. With eligibility for TTS, an excess ordinary business loss is a net operating loss (NOL) carryforward.

Section 988 allows traders to file a capital gains election to opt-out of Section 988 ordinary treatment. It must be done contemporaneously in your books and records. You can make, or retract, the opt-out election on a “good to cancel” basis at any time during the year. If you have a capital loss carryover, then consider a capital gains election.

The capital gains election on forex forwards allows the trader to use lower 60/40 capital gains rates in Section 1256(g). There are two requirements: It must be on “major currencies,” and the trader must not take or make delivery. “Major currencies” means currency pairs, which also trade as futures on U.S. commodities exchanges. We make a case for including “spot” forex in Section 1256(g). (See A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates.)

Foreign futures
By default, futures contracts listed on international exchanges are not Section 1256 contracts. If the international exchange wants Section 1256 tax treatment, they must obtain an IRS Revenue Ruling granting 1256 treatment. Only a handful of international futures exchanges have Section 1256 treatment: Eurex, LIFFE, ICE Futures Europe, and ICE Futures Canada. Foreign futures are otherwise ST or LT capital gains. (See Tax treatment for foreign futures.)

Precious metals
Physical precious metals are “collectibles,” which are a particular class of capital assets. If you hold collectibles over one year (long-term), sales are taxed at the “collectibles” tax rate — capped at 28%. (If your ordinary rate is lower, use that.) If you hold collectibles one year or less, the short-term capital gains ordinary tax rate applies no different from the regular STCG tax rate.

Volatility products
There are many different types of volatility-based financial products to trade, and tax treatment varies.

CBOE Volatility Index (VIX) futures are Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an exchange-traded fund (ETF), taxed as a security. The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN).

Volatility ETNs. Many issuers structure volatility ETNs as prepaid forward contracts (PFC), which provides a deferral of taxes until sale (realization). Long-term capital gains rates apply if held 12 months or longer. (i.e., VXX). However, prepaid forward contracts are not securities. Therefore, they are not subject to WS loss adjustments and Section 475 if elected. Many 1099-Bs treat ETN PFC as securities subject to WS. Consider departing from the 1099-B with footnote disclosure. Some ETNs, like UGAZ, are debt instruments taxed as securities, which means they are subject to WS losses and Section 475 if chosen. (Check the tax section of the ETN prospectus and see Other Financial Products.)

Cryptocurrencies
Selling, exchanging, or using cryptocurrency triggers capital gains and losses for traders. The IRS treats cryptocurrencies as intangible property; not a security or a commodity.

The realization method applies to short-term vs. long-term capital gains and losses. If you invested in cryptocurrencies and sold, exchanged, or spent some during the year, you have to report a capital gain or loss on each transaction. Include cryptocurrency-to-currency sales, crypto-to-alt-crypto trades, and purchases of goods or services using crypto.

U.S. cryptocurrency exchanges issue a Form 1099-K to accounts with transactions over a certain threshold. The problem for the IRS is that many cryptocurrency transactions on exchanges around the world are not evident for tax reporting. Cryptocurrency investors should download all crypto transactions into a crypto accounting program that is IRS-compliant.

Wash sales do not apply to intangible property. Use the first-in-first-out (FIFO) accounting method. Intangible property should use the specific identification method, but that requires broker confirmation of each trade, which is not possible.

TCJA restricted Section 1031 like-kind exchanges to real property, starting in 2018. That rules out using like-kind exchange on crypto-to-crypto trades (i.e., Bitcoin for Ethereum). It’s questionable whether crypto traders could have used Section 1031 before 2018 to defer capital gains taxes. The IRS promised the public more advice on crypto, and it recently mailed tax “education” notices to crypto traders. I hope the IRS addresses Section 1031, hard forks or chain splits, and several other open questions. (See Watch Out Cryptocurrency Owners; The IRS Is On The Hunt.)

Swap contracts
The Dodd-Frank financial regulation law promised to clear private swap transactions on exchanges to protect the markets from another swap-induced financial meltdown. Remember those credit default swaps with insufficient margin? When Congress enacted Dodd-Frank, traders hoped that clearing on futures exchanges would allow Section 1256 tax treatment. They were wrong: Congress and the IRS immediately communicated that Section 1256 would not apply to swap transactions, and they confirmed ordinary gain or loss treatment.

Roger D. Lorence JD contributed to this blog post.

Join my upcoming Webinar on October 23, 2019, or watch the recording after to learn more about this content: Trader Tax Strategies 2019 Year-End Update

For more information on wash sales and Section 475, see How Traders Get Enormous Tax Deductions, And Investors Do Not.

For more in-depth information, see Green’s 2019 Trader Tax Guide.

Trading Futures & Other Section 1256 Contracts Has Tax Advantages

May 30, 2019 | By: Robert A. Green, CPA | Read it on

There are various types of financial products with different tax treatments, and Section 1256 contracts have the best overall tax advantages.

Tax treatment of financial products affects investors, traders, and hedge funds. But sadly, many tax preparers overlook essential differences in tax treatment for these groups, resulting in overpayments. Education is key.

It’s important to distinguish between securities vs. Section 1256 contracts with lower 60/40 capital gains rates vs. other types of financial products like forex or swaps with ordinary income or loss treatment. Plus, there are various elections available to change tax treatment.

Capital gains vs. ordinary income
Most financial instruments — including securities, Section 1256 contracts, options, ETFs, ETNs, indexes, precious metals, and cryptocurrencies held as a capital asset — are subject to capital gains treatment. However, some of these financial products qualify as Section 1256 contracts with lower 60/40 capital gains rates.

By default, forex contracts and swap contracts are subject to ordinary gain or loss treatment. The distinction between ordinary and capital gains treatment makes a big difference. The capital-loss limitation is a problem for traders and investors who may have trouble using up large capital-loss carryovers in subsequent tax years. There is a Section 1256 loss carryback election.

Traders with trader tax status (TTS) and a Section 475 MTM election have business ordinary-loss treatment, which is more likely to generate tax savings or refunds faster than capital loss carryovers.

60/40 capital gains rates
Section 1256 contracts have lower 60/40 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.

At the maximum tax brackets for 2018 and 2019, the top Section 1256 contract tax rate is 26.8% —10.2% lower than the highest ordinary rate of 37%. Section 1256 tax rates are 4.2% to 12% lower vs. ordinary rates depending on which tax bracket applies.

For example: Make $100,000 in 1256 contracts in the 35% ordinary bracket, and save $12,000 (12%) with 60/40 rates.

For 2018 and 2019, there is meaningful tax rate reduction throughout the brackets, including zero long-term rates in the 10% and 12% ordinary brackets.

See Section 1256 tax rates vs. ordinary rates (2018 & 2019 rates). State tax rates apply; they do not include a long-term rate.

Trading income is not self-employment income (SEI) for triggering SE tax (FICA and Medicare). Traders who are full members of a futures or options exchange are an exception here; they have self-employment income under Section 1402(i) on their exchange-generated trading gains reported on Form 6781.

List of 1256 contracts

U.S. futures contracts:
– Regulated futures contracts (RFCs) on a qualified board or exchange (QBE).
– U.S. RFCs on commodities (food, energies, and metals), stock indexes, financials (U.S. Treasuries and bonds), currencies, and more.
– Options on U.S. futures (RFCs).
– Foreign futures with CFTC and IRS approval. (Only a handful of exchanges currently have this IRS revenue ruling, including Eurex, LIFFE, ICE Futures Europe, and ICE Futures Canada, see blog post).

Broad-based indexes:
– Broad-based indexes are stock index futures made up of 10 or more underlying securities.
– Options on broad-based indexes are also 1256 contracts.
– Broad-based indexes are taxed differently from exchange-traded funds (ETFs), which are securities.
– The S&P 500 Index (CBOE: SPX) is listed on a commodities exchange, taxed as a Section 1256 contract.
– The SPDR S&P 500 ETF Trust (NYSEARCA: SPY) is listed on a securities exchange, taxed as a security.

Other Section 1256 contracts:
– Options on commodities/futures ETFs taxed as publicly traded partnerships. (Options on securities ETFs are securities.)
– CBOE-listed options on volatility ETNs structured as prepaid forward contracts (the ETN itself is not Section 1256).
– Non-equity options. (Be careful in using this catchall.)
– Forex forward contracts on major currencies, if the taxpayer filed a Section 988 opt-out election to use Section 1256(g) (we make a case for forex spot in major currencies, too).
– Forex OTC options (Wright tax court case).

Mark-to-market accounting
Section 1256 contracts use mark-to-market (MTM) accounting daily. For income tax purposes, MTM means gain/loss calculations report both realized activity from throughout the year, and unrealized gains and losses on open trading positions at year-end. The broker 1099-B also reverses unrealized amounts from the prior year.

With MTM, wash sale (WS) loss adjustments are a moot point; hence, WS apply to securities, only, not 1256 contracts.With MTM, traders don’t have to do “tax loss selling” at year-end, since they will report the unrealized losses, anyway. Many traders have small or no open positions on Section 1256 contracts at year-end.

It might be hard to find an accurate MTM price for valuing long-term options (1256 contracts) at year-end. The broker might use one price on the December monthly statement and a significantly different value on the 1099-B for calculating unrealized gains and losses. Brokers use Options Clearing Corporation (OCC) for FMV, which might be from the last trade in the marketplace. That trade might not indicate the actual FMV.Some taxpayers use Black-Scholes modeling to determine a more accurate FMV.

Tax reporting
With Section 1256 MTM and summary reporting, brokers can issue simple one-page 1099-Bs reporting “aggregate profit or loss on contracts” after taking into account realized and unrealized gains and losses.

That amount is reported on Form 6781 Part I, which breaks it down to the 60/40 split and then moves those amounts to Schedule D capital gains and losses. See a 2019 Form 1099-B lines 8 – 11 for 1256 contract reporting.

One might expect that broker-issued 1099-Bs would handle all tax treatment issues, but for some financial products, they do not. Some brokers categorize CBOE-listed options on volatility ETNs, and ETFs structured as publicly traded partnerships as securities, but there is substantial authority to treat these CBOE-listed options as “non-equity options” included in Section 1256. (Options on securities ETFs are taxed as securities.)The most complicated issue for 1099-Bs is wash sale loss adjustments on securities.

Section 1256 traders should also learn about the “mixed straddle election” and “hedging rules” in Section 1256(d) and (e), and as discussed on Form 6781. Offsetting positions between Section 1256 contracts and securities can generate tax complications under certain circumstances involving the hedging rule. The IRS is concerned about traders reporting Section 1256 MTM unrealized losses and deferring unrealized gains on offsetting securities positions, so there are rules intended to prevent this.

Election to carryback Section 1256 losses
On Form 6781, select the “net section 1256 contracts loss election” in box D. Enter, but don’t deduct the loss on the current tax return. Remove the loss from Form 6781 on line 6. Apply the Section 1256 loss on amended tax return filings against Section 1256 gains only. (Form 1045 is preferable; otherwise, use Form 1040X.) It’s a three-year carryback, and unused amounts are then carried forward. It’s the only time traders can carryback a tax loss. TCJA repealed NOL carrybacks starting in 2018.

Section 475 election
Traders eligible for trader tax status (TTS) are entitled to file a timely election for Section 475 ordinary gain or loss treatment on securities and or commodities (including Section 1256 contracts). Generally, Section 475 is smart for securities traders, but not most 1256 contract traders. Ordinary losses are usually better than capital losses; however, ordinary income rates are worse than 60/40 capital gains rates.

TCJA introduced a new Section 199A “qualified business income” (QBI) deduction. Trading is a “specified service trade or business” (SSTB) subject to an income threshold, phase-in, and cap on the QBI deduction. QBI includes Section 475 ordinary income/loss, and trading business expenses. However, QBI excludes capital gains, 60/40 capital gains, portfolio income, and Section 988 and swap ordinary income. There is uncertainty about this QBI application to traders based on Section 864(b). It is better to use 60/40 capital gains rates.

Watch our Webinar recording: Trading Futures & Other Section 1256 Contracts Has Tax Advantages

ETNs Have Different Structures With Varying Tax Treatment

May 17, 2018 | By: Robert A. Green, CPA | Read it on

Exchange-traded notes (ETNs) are structured either as debt securities or prepaid executory contracts, and that makes a critical difference in tax treatment.

“The tax treatment of ETNs is often complicated to determine,” said New York City tax attorney Roger D. Lorence. “You have to review the tax section of each prospectus. In many cases, the offering is an undivided interest in the underlying positions, such as futures, so that the ETN is not an interest in an entity nor itself a security. However, other ETNs are structured as a debt instrument, usually with leverage concerning some index (such as natural gas futures).

ETNs structured as debt securities are taxed similarly to other securities with the realization method for capital gain or loss. (Realization is when you sell the security.) They are subject to Section 1091 wash-sale loss adjustments, which can raise tax liabilities. (Scroll to the end of the blog for more on wash-sale loss adjustments.) Section 475 ordinary gain or loss treatment should apply to these debt securities, too, if the trader qualifies for trader tax status (TTS) and makes the election on time.

ETNs organized as prepaid executory contracts (also referred to as prepaid forward contracts) are not securities. They calculate a rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. The ETN holder does not own the underlying instrument or index. This can have a significant impact on tax liabilities, as it likely means that Sections 1091 wash sales and 475 MTM should not apply to them. ETN prospectuses say they don’t address Sections 1091 and 475.

Report the sale or exchange of ETNs organized as prepaid executory contracts when realized as short-term and long-term capital gains and losses, except currency ETNs which are ordinary gain or loss treatment.

The problem
Here’s the problem when it comes time to preparing tax returns: Most brokers categorize all types of ETNs as securities on 1099-Bs and make wash-sale loss adjustments. Those adjustments might defer tax losses to the subsequent year, thereby raising tax liabilities. When it comes to ETN prepaid executory contracts, consider deviating from the 1099-B to reverse out wash-sale loss adjustments on these ETNs. Explain why in a tax return footnote. If this presents a significant change in tax liability, consider obtaining a “substantial authority” letter from a tax attorney to support the tax filing. The broker carries over these wash sale loss adjustments as an increase in cost basis in the subsequent year, so don’t forget to reverse that, too. Deviating from 1099-Bs raises complications, so consult a tax advisor.

Options on ETNs: There is a similar problem with CBOE-listed options on volatility ETNs and ETFs. Many broker 1099-Bs classify these options as securities, but there is substantial authority to treat them as non-equity options, which are Section 1256 contracts. As Section 1256 contracts, they are not subject to wash-sale loss adjustments and qualify for lower 60/40 capital gains tax rates. (See How To Apply Lower Tax Rates To Volatility Options, Tax Treatment For Exchange Traded Notes.)

ETN debt securities prospectus
See the Credit Suisse Velocity Shares prospectus applicable to ETN symbol XIV and five related volatility ETNs. Here are excerpts from pages 75-76:

“Debt Securities U.S. Holder Payments or Accruals of Interest Payments or accruals of ‘qualified stated interest’ (as defined below) on a debt security will be taxable to you as ordinary interest income at the time that you receive or accrue such amounts (in accordance with your regular method of tax accounting).

Purchase, Sale and Retirement of Debt Securities: When you sell or exchange a debt security, or if a debt security that you hold is retired, you generally will recognize gain or loss equal to the difference between the amount you realize on the transaction (less any accrued qualified stated interest, which will be subject to tax in the manner described above under Payments or Accruals of Interest) and your tax basis in the debt security.”

ETN prepaid executory contracts prospectus
Among the most-popular traded ETN symbols are VXX, VXZ, XVZ, all prepaid executory contracts issued by iPath. According to IPathETN.com U.S. Federal Income Tax Considerations, “For U.S. federal income tax purposes, Barclays Bank PLC and investors agree to treat all iPath ETNs, except certain currency ETNs, as prepaid executory contracts with respect to the relevant index. If such iPath ETNs are so treated, investors should recognize gain or loss upon the sale, redemption or maturity of their iPath ETNs in an amount equal to the difference between the amount they receive at such time and their tax basis in the securities. Investors generally agree to treat such gain or loss as capital gain or loss, except with respect to those iPath ETNs for which investors agree to treat such gain or loss as ordinary, as detailed in the chart below.”

The UBS Velocity Shares prospectus applicable to EVIX and EXIV states: “In the opinion of our counsel, Sullivan & Cromwell LLP, the Securities should be treated as a pre-paid forward contract…”

Volatility ETN products
In order of volume http://etfdb.com/etfdb-category/volatility/

– iPath S&P 500 VIX ST Futures ETN (VXX) – Prepaid*
– iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB) – Prepaid
– iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) – Prepaid
– iPath S&P 500 Dynamic VIX ETN (XVZ) – Prepaid
– iPath Series B S&P 500® VIX Mid-Term Futures ETN (VXZB) – Prepaid
– Credit Suisse VelocityShares Daily Long VIX Short-Term ETN (VIIX) – Debt**
– UBS VelocityShares VIX Short Volatility Hedged ETN (XIVH) – Debt
– UBS VelocityShares 1X Daily Inverse VSTOXX Futures ETN (EXIV) – Prepaid
– UBS VelocityShares VIX Variable Long/Short ETN (LSVX) – Debt
– UBS VelocityShares VIX Tail Risk ETN (BSWN) – Debt
– UBS VelocityShares 1X Long VSTOXX Futures ETN (EVIX) – Prepaid
Listed on securities exchanges: NYSE, Nasdaq, or Bats.

*Prepaid: The iPath volatility ETNs are prepaid executory contracts
**Debt: a debt security

Tax attorney weighs in
Lorence takes a look at the prospectus for the UGAZ ETN by Credit Suisse, which states that the offerings are short-term debt obligations, longer-term debt obligations, and warrants.

“The debt obligations are clearly described by tax counsel as producing interest income and similar interest-type income (e.g., market discount),” Lorence said. “Debt obligations are classified as securities for Section 1091; although there are issues about whether some commodities offerings, such as futures, are also securities, the UGAZ debt obligations would be securities for Section 1091. Wash sale rules for debt securities limit the substantially identicality of debt obligations by requiring that they be essentially the same bond for market value purposes (e.g., same issuer, same or virtually the same coupon and maturity). In all cases dealing with ETNs and ETFs, I have found these just to be marketing labels, and the tax consequences have to be found in the tax disclosure in the prospectus.”

Wash sale loss adjustments
Congress doesn’t want taxpayers to realize “tax losses” that are not “economic losses.” If you close a securities transaction and re-open it right away, you haven’t closed your financial position in that security. At year-end, many taxpayers do “tax loss selling” of securities in December, and the IRS wash sale rules defer the loss if the taxpayer re-purchases a substantially identical position within 30 days before or after, which means into January of the subsequent year. Thirty days is an eternity for day and swing traders. (Learn more about wash sales.)

See my earlier blog posts: How To Apply Lower Tax Rates To Volatility Options, Tax Treatment For Exchange Traded Notes and Tax Treatment For Volatility Products Including ETNs.

Darren Neuschwander CPA contributed to this blog post.

How To Apply Lower Tax Rates To Volatility Options

September 9, 2017 | By: Robert A. Green, CPA | Read it on

Update May 8, 2018: Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are debt obligations taxed as securities. (Check the tax section of the ETN prospectus.)

These days, volatility can be considered its own asset class, and many types of products have been created to fill this niche. If you trade volatility products, you may have many questions regarding how to treat these items on your tax return. But, guess what? Treatment for these items varies, and some of it is uncertain. Don’t sweat it, though — we are here to provide clarity.

Before delving into the various products and their treatment, it’s important to note that Section 1256 rules apply to “non-equity” options and Section 1256 items receive the coveted lower 60/40 tax rates. (At the maximum tax brackets for 2017, the top Section 1256 contract tax rate is 28% — 12% lower than the top ordinary rate of 39.6%. See 60/40 rates table.)

Several brokerage firms, however, classify options on volatility products as “equity options” taxed as securities. Our CPA firm established a substantial authority position to treat most of these volatility options as non-equity options. Don’t expect brokers to correct 1099-Bs if the tax treatment is uncertain. Be prepared to depart from the 1099-B reporting and include an explanation in footnotes and Form 8275. If your tax savings is significant, it’s wise to obtain a substantial authority opinion from a qualified tax attorney to protect against accuracy-related tax penalties.

CBOE-listed futures on VIX Indexes
Let’s start with a simple one. The CFE-traded VIX futures are “regulated futures contracts” (RFCs) on a qualified board or exchange (QBE). Because Section 1256 includes RFCs, I expect brokers to use Section 1256 for these products. There’s no uncertainty here.

CBOE-listed options on VIX Indexes, ETFs, and ETNs
IRS guidance is unclear, but these general rules should apply.

CBOE-listed options on VIX Indexes are not equity options, referencing a single equity price or narrow-based index of equity prices. They are likely non-equity options included in Section 1256, which references a barometer VIX Index, which does not contain equity prices. Most brokers agree.

CBOE-listed options on VIX securities ETFs, structured as registered investment companies (RICs), are likely equity options because a security ETF RIC acts like a single equity. Most brokers agree.

CBOE-listed options on VIX commodity ETFs, structured as publicly traded partnerships (PTPs), are likely non-equity options because a commodity ETF PTP is not a single equity or narrow-based equity index. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.

CBOE-listed options on VIX ETNs are likely non-equity options because an ETN is not a single equity or narrow-based equity index. An ETN is a prepaid executory contract. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.

The values of a narrow-based index must reference actual equity prices. The CBOE-listed options on VIX Indexes do not reference equity prices. Even the CBOE VIX Index for an individual equity (VXAPL) does not reference the equity price of APL, but rather the VIX barometer index for APL. Therefore, it’s likely that VXAPL is also a Section 1256 contract. (See CBOE-listed volatility options.)

Volatility ETFs
Issuers organize volatility ETFs as registered investment companies (RIC) or publicly traded partnerships (PTP). Tax treatment varies by the structure.

Securities ETFs: Securities ETFs are RICs. Selling securities ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method. RIC ETFs often make short- and long-term capital gains distributions to holders. Brokers report securities ETF proceeds and cost basis for each transaction on Form 1099-B.

Volatility ETFs organized as RICs include:
– REX VolMAXX Long VIX Weekly Futures Strategy ETF (VMAX)
– REX VolMAXX Short VIX Weekly Futures Strategy ETF (VMIN)

Commodities/futures ETFs: These ETFs use the PTP structure, also known as master limited partnerships (MLPs). PTPs issue annual Schedule K-1s passing through income or loss, including Section 1256 income or loss from trading within the PTP. Selling a commodity ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method.

Taxpayers invested in these ETFs should adjust cost-basis on Form 8949 (capital gains and losses and other income or loss), ensuring they don’t double count Schedule K-1 pass through income or loss. Form 1099-B does not make this cost-basis adjustment, so investors need to make a manual adjustment.

Volatility ETFs organized as PTPs include:
– ProShares VIX Short-Term Futures ETF (VIXY) S&P 500® VIX Short-Term Futures Index
– ProShares VIX Mid-Term Futures ETF (VIXM) S&P 500® VIX Mid-Term Futures Index
– ProShares Ultra VIX Short-Term Futures ETF (UVXY) S&P 500® VIX Short-Term Futures Index
-ProShares Short VIX Short-Term Futures ETF (SVXY) S&P 500® VIX Short-Term Futures Index.
– All are listed on the NYSE Arca securities exchange.

Volatility exchange traded notes
An exchange-traded note (ETN) calculates its rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. In IRS jargon, most ETNs are a “prepaid executory contract” or “prepaid forward contract” based on the relevant financial instrument or index. (A few ETNs are debt instruments, see more below.)

Report ETN income when realized (sold) as short- and long-term capital gains and losses. Exception: Report currency ETNs with Section 988 ordinary gain or loss treatment.

ETNs structured as prepaid forward contracts are not a security or a commodity, so they should not qualify for Section 475 ordinary gain or loss treatment used by traders eligible for trader tax status and who elected Section 475 on time.

Section 1091 wash sale loss rules apply to securities. ETNs, structured as prepaid forward contracts, are not securities, so they should be exempt from wash sale loss adjustments. Most 1099-Bs treat ETNs as securities, subjecting them to wash sale losses. Consider departing from the 1099-B, explain why on Form 8275, and in some cases, get a substantial authority opinion letter from a tax attorney.

The ETN holder does not own an underlying instrument or futures index, so he or she should not use Section 1256 treatment. In the VXX ETN prospectus, the tax attorneys suggested reasons why the IRS might apply Section 1256 as “possible alternative” tax treatment. But, they did not imply investors should try to use Section 1256 treatment. Our firm’s tax attorneys researched whether there is “substantial authority” for the position that 1256 applies to VXX and they concluded there is no substantial authority. (Read our rationale in our blog post: Tax Treatment For Exchange Traded Notes (ETNs))

Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are actual debt instruments, which are taxed as securities, and not prepaid forward contracts. Our tax attorney Roger Lorence says, “The tax treatment of ETNs is often difficult to determine. You have to review the tax section of each prospectus. In many cases, the offering is an undivided interest in the underlying positions, such as futures, so that the ETN is not an interest in an entity nor itself a security. However, other ETNs are structured as a debt instrument, usually with leverage with respect to some index (such as natural gas futures). In my experience “ETN” is a confusing and largely useless label and you have to go deeper to determine the tax characteristics.”

Volatility ETN products include:
In order of volume http://etfdb.com/etfdb-category/volatility/
– iPath S&P 500 VIX ST Futures ETN (VXX)
– iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)
– UBS VelocityShares 1X Daily Inverse VSTOXX Futures ETN (EXIV)
– UBS VelocityShares VIX Variable Long/Short ETN (LSVX)
– UBS VelocityShares VIX Tail Risk ETN (BSWN)
– UBS VelocityShares 1X Long VSTOXX Futures ETN (EVIX)
– iPath S&P 500 Dynamic VIX ETN (XVZ)
– Credit Suisse VelocityShares Daily Long VIX Short-Term ETN (VIIX)
Listed on securities exchanges: NYSE, Nasdaq, or Bats.

Options on volatility ETNs
The CBOE lists options on VXX (ETN). An IRS official in the Chief Counsel’s office for financial products explained to our tax attorney Roger D. Lorence that any option listed on CBOE or other qualified board or exchange whose reference is not a single symbol or a narrow-based index is a non-equity option in Section 1256. The equity option definition has two different prongs: single (equity) symbol and narrow-based (equity) index. Using this rationale, the IRS official said the option on VXX (ETN) is a non-equity option in Section 1256.

As mentioned earlier, our CPA firm established a substantial authority (SA) position to use Section 1256 tax treatment for CBOE-listed options on VIX Indexes, volatility ETF PTP, and ETNs (i.e., VXX). SA means it’s 33% likely to be correct, so tax preparers can sign a tax return including that position and avoid accuracy-related tax penalties.

If you are interested, contact our CPA firm at info@gnmtradertax.com.

Roger Lorence JD and Darren Neuschwander CPA contributed to this content.

Attend our Webinar on Sep. 12, 2017, or watch the recording: Tax Treatment For Volatility Products: Options, Futures,ETFs, and ETNs

How To Report Bitcoin Cash And Avoid IRS Trouble

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

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.

Tax Treatment For Exchange Traded Notes (ETNs)

July 11, 2017 | By: Robert A. Green, CPA | Read it on

Update May 8, 2018: Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are debt obligations taxed as securities. (Check the tax section of the ETN prospectus.)

An Exchange Traded Note (ETN) calculates its rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. In IRS jargon, an ETN is a prepaid executory contract or prepaid forward contract based on the relevant financial instrument or index. The ETN holder does not own the underlying instrument or index, so he or she should not use Section 1256 treatment. Report ETN income when realized as short-term and long-term capital gains and losses, except currency ETNs which are ordinary gain or loss treatment.

Is there an alternative tax treatment using Section 1256?
In my June 27, 2016, blog post Tax Treatment For Volatility Products Including ETNs, I said tax treatment for ETNs was uncertain. I wrote: In the iPath S&P 500 VIX ST Futures ETN (VXX: NYSEArca) prospectus, the tax attorneys suggested that Section 1256 is a “possible alternative” tax treatment. The VXX prospectus said: “Moreover, it is possible that the IRS could seek to tax your ETNs by reference to your deemed ownership of the Index components. In such a case, it is possible that Section 1256 of the Internal Revenue Code could apply to your ETNs, in which case any gain or loss that you recognize with respect to the ETNs that is attributable to the regulated futures contracts represented in the applicable Index could be treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, without regard to your holding period in the ETNs…”

My above 2016 blog post attracted lots of queries from ETN traders interested in tax advantageous Section 1256 treatment. Some ETN traders requested us to provide “substantial authority” for using Section 1256 treatment on VXX.

No “substantial authority” for using Section 1256 on VXX
Our tax attorney Mark M. Feldman JD, of counsel to Green, Neuschwander & Manning, LLC wrote the following.

I researched whether there is “substantial authority” for the position that 1256 applies to VXX. My conclusion is that there is no substantial authority. Substantial authority (in contrast to “reasonable basis”) requires that the position be anchored in some authority, and not simply be a reasonable possibility. See Treas. Reg. section 1.6662-4(d)(3).

We had discussed (see Green’s June 2016, blog post) whether Rev. Rul. 2008-1 might be relied upon to say that you look through to the underlying positions. After further analysis, and review of articles about Rev. Rul. 2008-1, my conclusion is that Rev. Rul. 2008-1 does not stand for the proposition that you look through to the underlying positions. Rather, Rev. Rul. 2008-1 should be understood as follows, based on its facts:

At inception, the holder delivers the U.S. dollar equivalent of 75 euros, and at maturity, the issuer is required to pay the U.S. dollar equivalent of 75 euros plus the U.S. dollar value at maturity on a return based on euro interest rates. Accordingly, the Service concluded that, for U.S. federal tax purposes, the Instrument is euro-denominated indebtedness of the issuer subject to Section 988. The fact that intervening currency fluctuations may cause the amount of U.S. dollars that the holder receives at maturity to be less than the amount of U.S. dollars that the holder paid at inception did not affect the characterization of the instrument of debt, which, according to the Service, was based on an analysis of payments with respect to the euros.

Thus, Rev. Rul. 2008-1 is simply an application of Section 988: treating this as debt which has an interest rate but is denominated in foreign currency. The Rev. Rul. might not be expanded to cases (like VXX) where the payment is more similar to a derivative contract. Even if the Rev. Rul. were so expanded, this would mean that VXX is treated as indebtedness, not that you look through to its underlying components.

The language of the VXX Prospectus (including the 2016 Prospectus), suggesting that one possible treatment would be to look through to the underlying components is based, presumably, on Notice 2008-2 (the “Notice”), not Rev. Rul. 2008-1. The Notice does not say that looking through is the proper treatment, but merely that the IRS is considering “whether the tax treatment of the transactions should vary depending on the nature of the underlying asset (for example, stocks vs. commodities).” That sentence is not sufficient to create substantial authority. (See also 2015 Tax Notes Today 202-8 “VIX IN STICKS AND VAX IN STACKS”, which references articles on VIX-related products and does not change this conclusion.)

In fact, in response to the Notice, there was a paper presented by the New York State Bar Association Tax Section (2008 Tax Notes Today 125-20, at note 26) which recommended to the IRS that Section 1256 60/40 treatment not be extended to ETNs.

New York City tax attorney Roger D. Lorence, of counsel to Green, Neuschwander & Manning LLC says, “I agree with Mark Feldman’s analysis. Instruments that are debt obligations (in form) do not give rise to 1256 treatment. The taxpayer would be arguing against the form of the transaction, which is problematic.”

Other ETNs
According to List of ETNs ExchangeTraded – First Bridge Data, there are many ETNs to trade on exchanges.

The iPath Bloomberg Commodity Index Total Return ETN (DJP) prospectus says its “senior secured debt securities.” The tax considerations section discusses taxation of securities, Original Issue Discount (OID), and variable rate securities. The DJP prospectus does not mention Section 1256.
The iPath GSCI Total Return Index ETN (GSP) product summary says its “unsecured debt obligations.” The GSP prospectus calls for “Notes Treated as Prepaid Forward or Derivative Contracts.” Like VXX, the prospectus mentions the IRS may assert alternative treatment based on Section 1256.

See IPathETN.com U.S. Federal Income Tax Considerations: “For U.S. federal income tax purposes, Barclays Bank PLC and investors agree to treat all iPath ETNs, except certain currency ETNs, as prepaid executory contracts with respect to the relevant index. If such iPath ETNs are so treated, investors should recognize gain or loss upon the sale, redemption or maturity of their iPath ETNs in an amount equal to the difference between the amount they receive at such time and their tax basis in the securities. Investors generally agree to treat such gain or loss as capital gain or loss, except with respect to those iPath ETNs for which investors agree to treat such gain or loss as ordinary, as detailed in the chart below.” The iPath chart lists currency ETNs subject to ordinary gain or loss treatment. That’s consistent with IRS Revenue Ruling 2008-1 analyzed above. The other ETNs call for capital gain and loss treatment.

ETN investors agree to tax treatment
ETN prospectuses and Website content, including iPath above, state “investors agree to treat all ETNs, except certain currency ETNs, as prepaid executory contracts.” That’s a departure from typical prospectuses which recommend holders adopt a particular tax treatment.

When ETN prospectuses mention alternative tax treatment calling for Section 1256, they say the IRS may assert Section 1256 mark-to-market treatment based on various factors; they are not recommending a holder consider using Section 1256 treatment.

Volatility products with Section 1256 treatment
If you want Section 1256 tax breaks on volatility products, then trade volatility futures like the CBOE Volatility Index (VIX).

Options on VXX ETN
Some clients asked me how options on VXX are treated for tax purposes. I got this reply from our tax attorney Roger D. Lorence. “I located nothing directly on point. However, the better view in my understanding would be that these options are nonequity options and therefore Section 1256 contracts. The options are listed on CBOE and are therefore listed options on a qualified board or exchange. The underlying is, e.g., VXX ETNs. The tax opinion in the prospectus for the ETNs (Sullivan and Cromwell) is that these are prepaid forward contracts, and the holder has an executory contract for the delivery of the underlying futures contracts. Therefore the CBOE listed options are a derivative contract several levels removed from the ultimate underlying. If a holder were to exercise the CBOE options theoretically, they would not receive equity in a single stock or a narrow-based group of stocks based on a narrow-based index.”

Tax attorneys Mark M. Feldman and Roger D. Lorence contributed to this blog post.

A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates

February 25, 2017 | By: Robert A. Green, CPA

Trading leveraged forex contracts off-exchange has different tax treatment from trading currency futures on-exchange. Currency futures automatically have lower “60/40 tax rates” in Section 1256, with 60% benefiting from lower long-term capital gains rates, even on day trading. It’s harder to achieve lower 60/40 tax rates on leveraged forex trading, but worth the effort since 60/40 rates are significantly lower. (See Several Ways To Trade Currencies, Some With Lower Tax Rates.)

Forex trading
Most American retail forex traders open accounts with a CFTC-registered Retail Foreign Exchange Dealer (RFED) or an FCM Forex Dealer Member. By default, off-exchange leveraged spot and forward forex contracts are Section 988 ordinary gain or loss tax treatment. A forex trader may elect capital gains treatment, which on short-term capital gains is the ordinary tax rate. If a forex trader doesn’t “take or make delivery” in cash, there is a case for using Section 1256(g) (foreign currency contracts) on “major” currencies if the trader meets the requirements of Section 1256(g)(2). The same tax treatment applies to Eligible Contract Participants (ECP). Tax treatment is uncertain for spot forex contracts traded with RFED and FCM Forex Dealer Members.

Section 988 foreign currency transactions
By default, spot and forward forex transactions in the interbank market start off in Section 988 “foreign currency transactions,” and they are subject to ordinary gain or loss tax treatment. A forex trader is entitled to file an internal, contemporaneous Section 988 opt-out election, otherwise called a capital gains election, for short-term capital gains and loss treatment. This election can be filed or retracted, on a “good to cancel basis” during the tax year.

Section 988(a)(1)(B) opt-out election: “A taxpayer may elect to treat any foreign currency gain or loss attributable to a forward contract, which is a capital asset in the hands of the taxpayer and which is not a part of a straddle, as capital gain or loss…” The election mentions forwards, not spot. That’s okay since Reg. 1. 988 equates spot forex trades with forwards. Reg. 1. 988-1(b) defines a spot forex contract, and 1.988-2(d)(i)(ii) provides that a spot contract that does not result in taking or making delivery of the nonfunctional currency is analogous to a forward “or similar contract.” The election excludes straddles, which are offsetting positions with substantially reduced economic risk. Straddles include arbitrage trades in forward contracts.

Section 1256(g)(2) foreign currency contracts
After filing a capital gains election, if the forex trader met three IRS requirements for Section 1256(g)(2) listed below, they may use Section 1256 for major currency pairs only. Minor currency pairs remain short-term capital gains. The IRS considers a forex currency pair to be “major” if the same pair trades as a regulated futures contract (RFC) on U.S. futures exchanges.

Section 1256(g)(2) requirements:

(i) “Which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts;
(ii) which is traded in the interbank market;
(iii) which is entered into at arm’s length at a price determined by reference to the price in the interbank market.”

Are retail forex dealers in the interbank market?
It’s uncertain where the IRS draws the line on interpreting (ii) “traded in the interbank market.” When the IRS wrote Section 1256(g) in the mid-1980′s, only banks participated in the interbank market. Advances in trading platforms like ECNs and new regulations established in the “Commodity Futures Modernization Act” (CFMA) of 2000 added new participants to the interbank market, including CFTC-registered Retail Foreign Exchange Dealers (RFED) and Futures Commission Merchant (FCM) Forex Dealer NFA-Members.

Some RFED and FCM forex dealers offer “no dealing desk” execution with immediate client trades made in the interbank market. Others are “dealing desks” offsetting client positions, and netting risk in the interbank market. (See Learn Why The NFA Barred FXCM And What It Means For Forex Traders.)

There is a sound argument for using Section 1256(g) treatment for RFED and FCM Forex Dealer Members, whether they are no-dealing or dealing desks. I am concerned the IRS may draw the line more narrowly, allowing Section 1256(g) for no-dealing desks, only. In the worst case scenario, the IRS could seek to exclude all RFED and FCM forex dealers arguing they are not participants in the interbank market. They are the “retail” window of the interbank market.

Thomson Reuters CheckPoint tax research on this questions states: “Contracts traded in the interbank market generally include contracts between a commercial bank and another person as well as contracts entered into with a futures commission merchant (FCM) who is a participant in the interbank market. According to the legislative history, a contract that does not have such a bank or FCM, or some other similar participant in the interbank market, is not a foreign currency contract.” The legislative history mentions “FCM, or some other similar participant in the interbank market.” I argue that “some other similar participant” could be a placeholder for RFED, created in 2000, well after Section 1256(g)(2) was written.

Can spot forex contracts be included in Section 1256(g)?
As explained above, Section 988 equated spot with forwards, if the trader does not take or make a delivery. Unfortunately, Section 1256(g) does not recognize spot forex contracts, so I make an argument for inclusion below.

Leveraged spot forex contracts, and forward forex contracts are similar trading products, whereas the IRS only mentioned forwards in the legislative history to Section 1256(g). After Congress had updated the code, it enacted the CFMA of 2000 ushering in leveraged retail off-exchange trading in the spot forex interbank market through CFTC-registered RFED and FCM Forex Dealer Members.

Spot forex contracts have a trade date when initiated, just like forward forex contracts. Spot contracts settle in 1-2 days, and forward contracts settle greater than two days. Forex traders do not “take or make delivery” on leveraged spot forex contracts. For example, with a $2,000 account deposit, a forex trader may buy a spot forex contract priced at $100,000 if using maximum leverage. They are unable to settle the contract in cash with just $2,000 in their account, and they close the trade before it settles, or roll it over. I consider a spot forex contract to be a shorter-term forward contract. Traders use spot forex contracts differently from a manufacturer who executes a “foreign currency transaction” in the spot interbank market for “immediate and fixed delivery.” Rollover fees are evidence of forex contracts for traders.

The Sixth Circuit Court of Appeals Wright decision helps
The Sixth Circuit Court of Appeals reversed the IRS tax court 2014 ruling on Wright vs. Commissioner (6th Cir. 1/7/2016). The case involved forex OTC options where the taxpayer used Section 1256(g) tax treatment. The IRS did not agree, but the appellate court overruled the IRS.

The Sixth Circuit relied on a “literal interpretation” of Section 1256(g)(2): “(i) Which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts.” The IRS argued forex OTC options don’t settle in cash due to their “optionality” and therefore do not meet this (i) requirement. The appellate court parsed the exact words and comma placements in Section 1256(g)(2) and decided the forex OTC options, in this case, did meet the (i) requirement.

The appeals ruling concluded if Congress and the IRS wanted to exclude a particular type of “foreign currency contract” from Section 1256(g), it should have updated the code accordingly, rather than rely on legislative history. Section 1256(g) does not exclude forex OTC options, so the Sixth Circuit included them.

Spot forex contracts have a stronger case for meeting Section 1256(g)(2)(i) than forex OTC options. Spot forex contracts settle in cash just like forward forex contracts, and they don’t have optionality. Additionally, Section 1256(g) does not exclude spot forex contracts.

I do not see where the appellate court or IRS reviewed how Wright met the second requirement of Section 1256(g)(2), “which is traded in the interbank market.” The court named the private companies that acted as counterparties to Wright on the forex OTC option transactions. The court did not mention the involvement of any banks, FCM or RFED in these transactions. Section 1256(g) does not exclude RFED and FCM forex dealers from being in the interbank market.

Forex OTC options are different from spot forex contracts. RFED don’t offer forex OTC options. Wright purchased forex OTC options with a private tax shelter promoter, not in the spot interbank market. Traders with foreign currency transactions in the spot forex interbank market start off in Section 988 ordinary gain or loss. The Wright court seemed to confer that Wright’s forex OTC options did not have to start in Section 988. Caution: Forex traders should not skip the required contemporaneous Section 988 opt-out election if they want to use Section 1256(g).

If you have any questions, please contact us.

Darren L. Neuschwander, CPA, Roger D. Lorence, JD and Mark Feldman JD contributed to this blog post.

Several Ways To Trade Currencies, Some With Lower Tax Rates

| By: Robert A. Green, CPA

Several Ways To Trade Currencies, Some With Lower Tax Rates

There are several ways for American retail traders to trade “currencies” and tax treatment varies.

1. U.S. regulated futures contracts
U.S. futures exchanges list the major currency pairs as regulated futures contracts (RFCs). Open a retail account with a CFTC-registered Futures Commission Merchant (FCM).

Currency RFCs automatically have Section 1256 tax treatment with lower 60/40 tax rates. Section 1256 requires mark-to-market (MTM) accounting, which means reporting realized and unrealized capital gains and losses. Because there is no way to generate a long-term capital gain with MTM, Congress agreed that 60% is a long-term capital gain, and 40% is a short-term capital gain, no matter of holding period. (See Section 1256 tax rates vs. ordinary rates below.)

2. Leveraged forex contracts off-exchange
Most American retail traders open accounts with a CFTC-registered Retail Foreign Exchange Dealer (RFED) or an FCM Forex Dealer Member. (See Learn Why The NFA Barred FXCM And What It Means For Forex Traders.)

By default, foreign currency transactions, including spot and forward forex contracts are Section 988 ordinary gain or loss tax treatment. A forex trader may elect capital gains treatment, which on short-term capital gains is the ordinary tax rate. If a forex trader doesn’t “take or make delivery” in cash, there is a case for using Section 1256(g) (foreign currency contracts) on “major” currencies. (See A Case For Retail Forex Traders Using Section 1256(g).)

3. Currency exchange-traded funds (ETFs)
Structured as Registered Investment Companies (RIC) listed on a securities exchanges, ETF RICs are securities with short-term vs. long-term capital gains and losses treatment, using the realization method. Short-term capital gains are subject to ordinary tax rates, and capital losses are subject to the $3,000 capital loss limitation against other income.

4. Nadex binary options and spreads based on forex
Nadex is a CFTC-registered derivative exchange offering binary options and spreads. Nadex bases one of its binary options products on price movements in forex. It’s not a forex contract. Nadex issues a Form 1099B for Section 1256 contracts, but I have doubts about their qualification for using Section 1256 tax treatment. Nadex binary options and spreads appear to be “swap contracts” with ordinary gain or loss tax treatment. (Read Tax Treatment For Nadex Binary Options.)

Section 1256 tax rates vs. ordinary rates
The difference in the 60/40 blended tax rate vs. short-term capital gains taxed at ordinary rates is significant throughout the graduated tax brackets. The 60/40 rates vs. ordinary rates are:

4% for the 10% bracket,
6% for the 15% bracket,
19% for the 25% bracket,
20% for the 28% bracket,
22% for the 33% bracket,
23% for the 35% bracket, and
28% for the top 39.6% bracket

No matter what tax bracket you are in, there are significant tax savings using Section 1256.

Additionally, there is a Section 1256 loss carryback election, which can be used to amend the prior three years tax returns, offsetting Section 1256 gains only. Section 1256 has summary tax reporting. It’s a breeze tax-wise.

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

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

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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