I consulted dozens of cryptocurrency (coin) traders on taxes in December and confirmed what the media has been reporting: Coin traders made fortunes in 2017. Now that the 2017 tax-filing season is underway, these traders should gather online tax reports if available, use a coin trade accounting program, and review the latest guidance on tax treatment.
Coinbase has a new online tax report
On July 6, 2017, the IRS narrowed its summons against Coinbase, the most substantial U.S.-based coin exchange, to retrieve larger customers’ trades and other transactions to find unreported income. In late-December 2017, Coinbase added tax reporting of capital gains and losses using first in first out (FIFO). This move should undoubtedly please the IRS since there is no 1099-B issuance on coin trades.
Update Feb. 2, 2018: Coinbase issued 2017 Form 1099-Ks to “qualifying customers,” including businesses, and traders, over specific volume thresholds. (See 1099-K Tax Forms). The IRS intended 1099-K for businesses (merchants) to report Payment Card and Third Party Network Transactions. (See Understanding Your Form 1099-K.)
Capital gains and losses
If you invested in cryptocurrencies and sold, exchanged, or spent it in 2017, you have to report a capital gain or loss on each transaction, including coin-to-currency sales, coin-to-coin trades, and purchases of goods or services using a coin. Deduct coin fees and other expenses appropriately.
Some coin deals naturally generate taxable income, including coin-to-currency trades and mining income. For example, Bitcoin sold for U.S. dollars is a noticeable capital gain or loss reportable on Form 8949. Or, when a coin miner receives a coin for his work, he or she naturally recognizes business revenue based on the value of the coin.
The big problem for the IRS is that most other coin transactions are not evident for tax reporting, including coin-to-coin trades, hard forks (chain splits), and using a coin to purchase goods and services. The coin investor should “impute” a sales or exchange transaction to report a capital gain or loss on coin-to-coin trades and using a coin to purchase items. Many coin investors and their accountants overlook or mishandle this reporting and underpay the IRS.
The IRS labels coin “intangible property.” Coin users may call it “digital money,” but it’s not sovereign government-issued money. That’s the critical difference: Each use of money is not a taxable event. Imagine having to report a capital gain or loss every time you purchased an item or asset with cash or a credit card. That would be ridiculous.
Most taxpayers comprehend that if they purchased Bitcoin in 2016 for $10,000 and sold in 2017 for $30,000, they should report a capital gain of $20,000 on their 2017 tax return form 8949. A coin position held for one year or less is considered a short-term capital gain, taxed at ordinary tax rates (up to 39.6% for 2017 and 37% for 2018). A coin position held for more than one year is considered a long-term capital gain, taxed at capital gains rates (up to 20% for 2017 and 2018).
Capital losses offset capital gains in full, and a net capital loss is limited to $3,000 against other types of income on an individual tax return. An excess capital loss is carried forward to the subsequent tax year(s), and it may not be carried back to a prior year. Some coin traders will pay massive taxes on capital gains in 2017 and get stuck with a capital loss limitation and carryover in 2018.
Many coin traders actively make coin-to-coin trades like Bitcoin to Ethereum and then Ethereum to Litecoin. Currently, coin investors purchase alt coins using Bitcoin or Ethereum.
Many taxpayers and preparers delay capital gains income on coin-to-coin trades by inappropriately classifying them as Section 1031 “like-kind exchanges,” where they may defer income to the replacement position’s cost basis. While the IRS hasn’t provided guidance on this matter, I do not believe the majority of coin-to-coin trades made on coin exchanges qualify for Section 1031 transactions as they fail one or both of the two primary requirements (and both are required). First, Bitcoin may not be a like-kind property with Ethereum. Second, coin-to-coin trades executed on coin exchanges do not constitute a direct two-party exchange, and coin exchanges are likely not qualified intermediaries in a multi-party exchange.
Coin-to-coin trading reminds me of forex trading between different currency pairs. Various currencies are not like-kind property (i.e., U.S. dollars are not a like-kind property with euros). Each coin has its version of a blockchain, and the network of users has a different purpose for each coin.
I asked coin tax expert Jim Calvin, Partner of Deloitte and author of When (and If) Income is Realized from Bitcoin Chain-Splits, if he thought these trades could qualify for Section 1031 like-kind exchange treatment in 2017 and prior years.
“It is neither a simple nor single factual issue,” he said. “It is not just whether the swapped coins are like-kind property, but also whether all the other requirements of Section 1031 can be met including the use of intermediaries.”
Atomic swaps or atomic cross-chain trading started in August 2017. The new technology allows a direct two-party exchange, bypassing coin exchanges. That may meet one requirement, but the coins must also be a like-kind property for Section 1031 deferral.
Tax Cuts and Jobs Act and coin traders
Starting in 2018, the Tax Cuts and Jobs Act limits Section 1031 like-kind exchanges to real property, not for sale. Investors may not use it on artwork, collectibles, and other tangible and intangible property, including cryptocurrencies.
The Act introduced Section 199A, a 20% deduction on qualified business income (QBI) in pass-through entities, subject to thresholds, limitations, and haircuts. A trader tax status (TTS) coin trader likely does not qualify for the deduction because he or she has capital gains income, excluded from QBI. This is different from a TTS securities trader who can elect Section 475 MTM ordinary income, which is included in QBI.
Coin hard forks (chain-splits)
The IRS has not provided guidance on hard fork transactions, and tax experts and coin traders debate its tax treatment. Bitcoin had a hard fork in its blockchain on Aug. 1, 2017, dividing into two separate coins: Bitcoin and Bitcoin Cash. Each holder of a Bitcoin unit was entitled to arrange receipt of a unit of Bitcoin Cash. Some Bitcoin holders did not gain immediate access to be able to sell Bitcoin Cash, so they may feel it’s okay to defer income on the fork transaction until they obtain such access, or later sell it. Coinbase did not support Bitcoin Cash when it forked, but it did add it to accounts for rightful holders in late-2017.
It’s reasonable that coin traders should not have to report taxable income on a hard fork until the new coin is time-stamped as a ledger entry, sending the coins to new outputs in the blockchain. Facts and circumstances on hard forks vary widely. An “old fork” could die out if miners collectively switch over to the new blockchain and abandon the old coin. Bitcoin Cash successfully forked from Bitcoin; both trade at higher values today than on the fork date. Hard forks frequently happen, and their initial fair market value varies significantly across coin exchanges.
“Taxable income is realized if the owner of pre-split bitcoin exercises dominion and control over the corresponding chain-split coins, and the income realized will be equal to the value of the chain-split coins at that time,” Calvin said. “Most owners holding Bitcoin on exchanges were unable to control if and when chain-split coins were claimed, the time income was realized, and may still be unaware of the date or value to use.”
I think many Bitcoin Cash holders had dominion and control over the new coin sometime in 2017, and they should recognize ordinary income on receiving it.
Coin trade accounting programs
Coin tax reporting is complex and voluminous. Consider two coin accounting solutions: Bitcoin.Tax and CoinTracking.Info.
The IRS calls for the “specific identification” (SI) accounting method for use on sales of property, including intangible property (coin). IRS regulations for SI require “adequate identification” of lots sold on a contemporaneous basis, and I don’t think most coin traders comply with these rules. In June 2016, the AICPA asked the IRS if coin traders could use “first in first out” (FIFO) as an alternative solution, which the IRS permits for securities. Unless you comply with SI rules, I suggest using the FIFO accounting method for coin. (See Accounting Method Impacts Crypto Income Taxes.)
Because the IRS labels coin intangible property, wash-sale loss rules likely don’t apply. TTS traders using Section 475 ordinary gain or loss on securities and/or commodities (Section 1256 contracts) may not use Section 475 on a coin since it’s not a security or a commodity in the eyes of the IRS.
How to deduct coin-trading costs
Coin traders pay various transaction costs, fees, and interest expenses in coin and currency. Be sure to convert coin expenses to U.S. dollars at the time spent. It’s critical to distinguish between tax categories — transaction costs, investment expenses, investment interest expenses, and trading business expenses — as they are all handled differently on tax returns.
Transaction fees can be deducted from sales proceeds and then added to cost basis for purchases, so reflect them on net capital gains and losses. These charges include trading costs (approximately 0.25%) paid to a coin exchange and fees paid to miners when transferring coin between addresses to get transactions into the next block.
The new tax law suspends investment expenses for 2018, but you can still deduct them as a miscellaneous itemized deduction for 2017 (if they are more than 2% of AGI). These costs include bank wire transfer fees for transferring currency to a coin exchange; loan or borrow fees paid to a coin exchange; and withdrawal fees paid to a coin exchange for removing money or coin. (It’s essential to separate loan fees vs. margin interest, as they have different tax treatment.)
Investment interest expense can be an itemized deduction, limited to investment income, with the excess carried over to the subsequent tax year. This includes interest on borrowed funds paid in coin to lender/exchange. The new tax law did not change the rules for investment interest expenses.
Trading business expenses are deducted from gross income. If the coin trader qualifies for TTS, investment expenses and investment interest expenses are deducted as business expenses on Schedule C or through an entity.
Miners deduct business expenses against revenues.
Example: Purchasing goods and services with coin
On Jan. 1, 2017, Joe bought 100 Bitcoins at a price of $998 each, for a total cost basis of $99,800. On June 1, 2017, when the price of a Bitcoin unit was $2,452, Joe used a Bitcoin to purchase a computer for $2,452. Without realizing it, Joe triggered a reportable short-term capital gain on his 2017 Form 8949. The sales proceeds are $2,452, representing the fair market value of the Bitcoin he used to purchase the computer. His cost basis for that one Bitcoin unit used is $998, so his net short-term capital gain is $1,454. If Joe uses the computer in his business, he will deduct $2,452 as an expense.
I suggest coin traders calculate capital gains and losses on coin transactions, including coin-to-coin trades made on exchanges, and use the FIFO accounting method. File an extension by the due date of your tax return (April 17, 2018, for individuals), and pay taxes owed for 2017 with the extension. During the additional time (file by Oct. 15, 2018), perhaps the IRS will answer our questions, including which if any coin-to-coin trades may use Section 1031 deferral in 2017. If the IRS allows it, maybe coin traders can still file that way on an original tax return filing. Consult a coin tax expert.
For more information, see Green’s 2018 Cryptocurrency Tax Guide.
If you have any questions, contact us.