Active cryptocurrency (coin) traders can qualify for trader tax status (TTS) to deduct trading business expenses and home-office deductions. TTS is essential in 2018: The Tax Cuts and Jobs Act suspended investment expenses, and the IRS does not permit employee benefit plan deductions on investment income. A TTS trader can write off health insurance premiums and retirement plan contributions by trading in an S-Corp with officer compensation.
The benefits of Section 475
There’s an additional critical tax benefit with TTS: Electing Section 475 mark-to-market accounting (MTM) on securities and/or commodities. Section 475 turns capital gains and losses into ordinary gains and losses thereby avoiding the $3,000 capital-loss limitation and wash-sale loss adjustments on securities (this is what I like to call “tax-loss insurance”). Many coin traders incurred substantial trading losses in Q1 2018, and they would prefer ordinary loss treatment to offset wage and other income. Unfortunately, most coin traders will be stuck with significant capital-loss carryforwards and higher tax liabilities.
There are benefits to 475 income, too. The new tax law ushered in a 20% pass-through deduction on qualified business income (Section 199A), which likely includes Section 475 ordinary income, but excludes capital gains. Trading is a specified service activity, requiring the owner to have taxable income under a threshold of $315,000 (married) or $157,500 (other taxpayers). There is a phase-out range above the limit of $100,000 (married) and $50,000 (other taxpayers).
The IRS says cryptocurrency is intangible property
In March 2014, the IRS issued long-awaited guidance declaring coin “intangible property,” before regulators thoroughly assessed coin. Section 475 is for securities and commodities and does not mention intangible property. An AICPA task force on virtual currency asked the IRS for further guidance (AICPA letter), including if coin traders could use Section 475. The IRS has not yet replied. When an investor holds cryptocurrencies as a capital asset, they should report short-term vs. long-term capital gains and losses on Form 8949. (See Cryptocurrency Traders Owe Massive Taxes For 2017.)
SEC and CFTC weigh in
The U.S. Securities and Exchange Commission (SEC) recently stated Initial Coin Offerings (ICOs) might be securities offerings, which most likely need to register with the SEC. It further said coins or tokens might be securities, even if the ICO calls them something else. According to an SEC statement, “If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.” (See SEC ICO information.)
The U.S. Commodity Futures Trading Commission (CFTC) defined cryptocurrencies as commodities in 2015. During a March 7, 2018, CNBC interview, Commissioner Brian Quintenz said the CFTC has enforcement authority, but not oversight authority, over cryptocurrencies traded in the spot market on coin exchanges. The CFTC has enforcement and oversight authority for derivatives traded on commodities exchanges, like Bitcoin futures.
Also on March 7, 2018, a U.S. district judge in New York ruled in favor of the CFTC, stating “virtual currencies can be regulated by CFTC as a commodity.” (See Cryptos Are Commodities, Rules US Judge In CFTC Case.)
Will the IRS change its mind?
There is a long-shot possibility the IRS could change its tune to treat cryptocurrency as a security and or a commodity as a result of recent actions from the SEC and CFTC, including the statements mentioned above. Then coin might fit into the definition of securities and/or commodities in Section 475. Until and unless the IRS updates its guidance, coin is intangible property, which is not listed in Section 475.
If you incurred substantial trading losses in cryptocurrencies in Q1 2018, and you qualify for TTS, you might want to consider making a protective 2018 Section 475 election on securities and commodities by April 17, 2018 (or by March 15 for partnerships and S-Corps). The IRS has a significant workload drafting regulations for the new tax law, and with limited resources, I don’t expect it to update coin guidance shortly.
There is a side effect of making a 475 election on commodities: If you also trade Section 1256 contracts, you surrender the lower 60/40 capital gains rates. Perhaps, you only trade coin and don’t care about Section 1256 contracts. If coin is deemed a commodity for tax purposes, it’s still likely not a Section 1256 contract unless it lists on a CFTC-registered qualified board or exchange (QBE). Coin exchanges or marketplaces are currently not QBE.
Section 475 provides for the proper segregation of investment positions on a contemporaneous basis, which means when you buy the position. If you have a substantial loss in coin that you’ve held onto for months before the sale, the IRS will likely consider it a capital loss on an investment position.
Bitcoin futures trade on the CME and CBOE exchanges. The product appears to be a regulated futures contract (RFC) trading on a U.S. commodities exchange, meeting the tax definition of a Section 1256 contract. That means it also fits the description of a commodity in Section 475.
Section 1256 contracts have lower 60/40 capital gains tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate, and 40% are taxed at the short-term rate, which is the ordinary tax rate. Section 1256 is mark-to-market accounting, reporting unrealized gains and losses at year-end.
TTS traders usually elect 475 on securities only to retain these lower rates on Section 1256 contracts. A Section 1256 loss carryback election applies the loss against Section 1256 gains in the three prior tax years, and unused amounts are carried forward.
If a TTS trader has a substantial loss in Bitcoin futures, he or she should consider making a 2018 Section 475 election on commodities for ordinary loss treatment. (See Consider 475 Election By Tax Deadline To Save Thousands.)
Cryptocurrency investment trusts
According to Grayscale’s website, the company is “the sponsor of Bitcoin Investment Trust, Bitcoin Cash Investment Trust, Ethereum Investment Trust, Ethereum Classic Investment Trust, Litecoin Investment Trust, XRP Investment Trust and Zcash Investment Trust. The trusts are private investment vehicles, are NOT registered with the Securities and Exchange Commission.” The Grayscale cryptocurrency investment trusts list on OTC markets.
According to its prospectus, Bitcoin Investment Trust is a Grantor Trust, a publicly traded trust (PTT). “Treatment of an interest in a grantor trust holding crypto assets means that you have to look through the trust envelope to the underlying positions,” says New York tax attorney Roger Lorence JD.
It’s similar to other PTTs; like the SPDR Gold Shares (NYSEArca: GLD) with long-term capital gains using the collectibles tax rate applicable to precious metals. With the look-through rule, the cryptocurrency investment trusts are subject to taxation as intangible property.
Excess business losses
The new tax law limits current year business losses to $500,000 (married) and $250,000 (other taxpayers) starting in 2018. The excess business loss carries forward as a net operating loss (NOL). In 2017, there wasn’t a limit, and taxpayers could carryback NOLs two tax years and/or forward 20 years. Section 475 losses often generated immediate tax refunds from NOL carryback returns. At least NOL carryforwards are better than capital loss carryovers.
Several coin traders face a tax trap
They had massive capital gains in 2017 and had not yet paid the IRS and state their 2017 taxes owed. Meanwhile, in Q1 2018, their coin portfolios significantly declined in value, and they incurred substantial trading losses. They now face a significant tax problem: They need to sell cryptocurrencies to raise cash to pay their 2017 tax liabilities due by April 17, 2018. That would leave many of them with little coin left to continue trading. They may choose to file their automatic extensions without tax payment or a small payment and incur a late-payment penalty of 0.5% per month by the extension due date of Oct. 15, 2018. They are banking on coin prices increasing and thereby generating trading gains by Oct. 15. It reminds me of trading on margin; only the bank (in this case, tax authorities) cannot force a sale now. (See Tax Extensions: 12 Tips To Save You Money.)
A Section 475 election is not a savior in this situation: Section 475 turns 2018 capital losses into ordinary losses on TTS positions, but the IRS no longer allows NOL carryback refunds. In prior years, a trader with this problem could hold the IRS at bay, promising to file an NOL carryback refund claim to offset taxes owed for 2017.
Mining inventory vs. capital assets
When a miner receives coin, it’s revenue. The net income after mining expenses is ordinary income and self-employment income. If the miner converts that coin from mining inventory to a capital asset, subsequent sales or exchanges of that coin are capital gains and losses, not ordinary income or loss. Most coin accounting programs assume a conversion to capital asset treatment takes place. However, a miner may not intend to convert coin to a capital asset, and instead leave the coin in inventory. A subsequent sale or exchange would then be an ordinary gain or loss as part of the mining business.
How to qualify for trader tax status
Are you unsure if you are eligible for TTS? Here are the GreenTraderTax golden rules for qualification based on an analysis of trader tax court cases and years of tax compliance experience.
- Volume: three to four trades per day. Don’t count when the coin exchange breaks down an order into multiple executions.
- Frequency: trade executions on 75% of available trading days. If you trade five days per week, you should have trade orders executed on close to four days per week.
- Holding period: The Endicott court required an average holding period of fewer than 31 days.
- Hours: at least four hours per day, including on research and administration.
- Taxable account size: material to net worth, and at least $15,000 during the year.
-Intention to make a primary or supplemental living. You can have another job or business, too.
- Operations: one or more trading computers with multiple monitors and a dedicated home office.
- Automation: You can count the volume and frequency of a self-created automated trading system, algorithms or bots. If you license the automation from another party, it doesn’t count.
- A trade copying service, using outside investment managers and retirement plan accounts don’t count for TTS.
If you qualify for TTS, claim it by using business expense treatment rather than investment expenses. TTS does not require an election, but 475 does.
In 1997, Congress recognized the growth of online trading when it expanded Section 475 from dealers to traders in securities and commodities. It was when I created GreenTraderTax, urging clients and followers in chat rooms to elect 475 for free tax-loss insurance. When the tech bubble burst in 2000, those that followed my advice were happy to get significant tax refunds on their ordinary business losses with NOL carrybacks. I wish Section 475 were openly available to all TTS coin traders now.
Darren Neuschwander CPA contributed to this blog post.