Tag Archives: other

Other Financial Products

August 29, 2014 | By: Robert A. Green, CPA

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. (Read our blog Tax Treatment for Foreign Futures, to see the list of exchanges with this IRS approval.) Remember, Section 1256 tax treatment uses MTM accounting at year-end. Foreign futures without Section 1256 are reported like securities using the realization method for ST vs. LT capital gains.

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” capital gains tax rate — capped at 28%. That rate is higher than the top regular long-term capital gains rate of 20% (2019 and 2020). (If your ordinary rate is lower than collectibles rate, then 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. Precious metals are not securities, so wash-sale loss adjustments, and Section 475 does not apply. Read our blog post: Tax Treatment for Precious Metals.

Volatility Exchange Traded Notes (ETNs)

There are many different types of volatility-based financial products to trade, and tax treatment varies. For example, CBOE Volatility Index (VIX) futures are taxed as Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an ETF taxed as a security.

Volatility ETNs are structured as “prepaid forward contracts” or as “debt instruments.” Our tax counsel says that an ETN prepaid forward contract is not considered a security by the IRS, whereas, ETN debt instruments are.

Sales of ETN prepaid forward contracts use the realization method on sales. Long-term capital gains rates apply if held 12 months or longer. Because it’s not a security, ETN prepaid forward contracts (i.e., VXX) are not subject to wash-sale loss adjustments and Section 475 (if elected). ETNs debt instruments (i.e., UGAZ) are securities and are subject to wash sale losses and Section 475 (if elected). Check the tax section of the ETN prospectus.

There is substantial authority to treat CBOE-listed options on volatility ETNs, and on volatility ETFs structured as publicly traded partnerships as “non-equity options” with Section 1256 treatment. See our blogs: How To Apply Lower Tax Rates To Volatility Options, and ETNs Have Different Structures With Varying Tax Treatment.

In preparing Form 1099-Bs, many brokers use the tax classification determined by exchanges for labeling securities vs. 1256 contracts. Some brokers treat both types of ETNs as securities on 1099-Bs with wash sale loss adjustments, even though prepaid forward contracts do not fall in that category. Some brokers treat CBOE-listed options on volatility ETNs and ETF PTPs as securities on Form 1099-Bs, even though they are eligible for Section 1256 treatment. Taxpayers can depart from 1099-Bs based on substantial authority positions and explain why in a tax return footnote.

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 Dodd-Frank was enacted, 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. Read our blog post: Tax Treatment for Swaps Options.

Tax Treatment For Nadex Binary Options

June 20, 2014 | By: Robert A. Green, CPA

There’s a bevy of financial instruments to trade on securities and futures exchanges around the world, and derivatives and swaps exchanges offering binary options and swap contracts are increasingly becoming part of the mix. How are these unique instruments treated come tax-time? Can they be considered Section 1256? Let’s delve into binary options and swaps in more detail. (For more background on Section 1256 and its qualified board or exchange requirement, see Tax treatment for foreign futures.”)

Dodd-Frank changed the law
A principal focus of the Dodd-Frank Wall Street Reform and Consumer Protection Act law enacted in July 2010 is better regulation and control of the several-hundred-trillion-dollar derivatives and swaps marketplace. Dodd-Frank requires many privately negotiated derivatives and swaps contracts to clear on derivatives and swaps exchanges to insure collection of margin and to prevent another financial crisis. Remember, AGI wrote too many derivatives and swaps contracts, which it did not have sufficient capital or margin to pay out when markets melted down and counterparties demanded payment in 2008.

Dodd-Frank synchronized regulation and tax law, requiring the IRS to exclude swap contracts from Section 1256. Although Congress required private derivative contracts to clear on Section 1256 exchanges, it didn’t want to reward derivatives contracts with Section 1256 tax advantages.

Before Dodd-Frank, the CFTC had more leeway in designating instruments as “options.” According to a CFTC lawsuit, the CFTC used a limited definition of what constituted an option; e.g. it trades like an option (more on this lawsuit later). According to a CFTC official, “After Dodd-Frank, unless the option expires into a futures contract, the CFTC categorizes it as a swap contract. If the contract expires into cash, it’s a swap contract.”

Regulators don’t drive tax treatment
The Securities and Exchange Commission (SEC) regulates securities and the IRS treats sales of securities with short-term and long-term capital gain/loss tax treatment based on realized gains subject to wash sale loss deferral rules. The Commodity Futures Trading Commission (CFTC) regulates commodities, futures, forex and derivatives and the IRS has varying tax treatment for these different types of financial instruments.

Regulated futures contracts and nonequity options are Section 1256 contracts afforded lower 60/40 capital gains tax rates with MTM accounting reporting realized and unrealized gains and losses at year-end (reported on Form 6781).

If an investor sells physical commodities, capital gain/loss treatment applies and there is no MTM. Conversely, if a farmer sells physical commodities, ordinary treatment applies, but again, there is no MTM.

Forex (interbank spot and forward contracts) falls under Section 988 ordinary gain and loss on realized transactions. Traders may file a contemporaneous “capital gains election” to opt out of Section 988, whereas manufacturers may not.

Notional principal contracts defined as two or more periodic payments — commonly called swaps — receive ordinary gain or loss treatment and MTM accounting applies.

IRS proposed regulations on swaps 
In connection with Dodd-Frank, the IRS issued proposed regulations “Notice of Proposed Rulemaking and Notice of Public Hearing Swap Exclusion for Section 1256 Contracts” (REG-111283-11) on Oct. 17, 2011. Excerpts are provided below, with our notes in italics:

• Summary: .. describe swaps and similar agreements that fall within the meaning of section 1256(b)(2)(B). This document also contains proposed regulations that revise the definition of a notional principal contract under §1.446-3 (Note that swaps generally fall within the definition of “Notional Principal Contracts”.)

• Dodd-Frank Act added section 1256(b)(2)(B), which excludes swaps and similar agreements from the definition of a section 1256 contract. Section 1256(b)(2)(B) provides that the term “section 1256 contract” shall not include— any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. (All swaps are effectively excluded.)

• Congress enacted section 1256(b)(2)(B) to resolve uncertainty under section 1256 for swap contracts that are traded on regulated exchanges. .. increased exchange-trading of derivatives contracts by clarifying that section 1256 of the Internal Revenue Code does not apply to certain derivatives contracts transacted on exchanges. (Nadex binary options trade on a regulated exchange.)

• Option on a notional principal contract
Section 1256(b)(2)(B) raises questions as to whether an option on a notional principal contract that is traded on a qualified board or exchange would constitute a “similar agreement” or would instead be treated as a nonequity option under section 1256(g)(3). Since an option on a notional principal contract is closely connected with the underlying contract, the Treasury Department and the IRS believe that such an option should be treated as a similar agreement within the meaning of section 1256(b)(2)(B). (If a Nadex binary option were deemed an option on a NPC, it would be excluded as a NPC per this rule.)

• Ordering rule
The proposed regulations provide an ordering rule for a contract that trades as a futures contract regulated by the Commodity Futures Trading Commission (CFTC), but that also meets the definition of a notional principal contract. The Treasury Department and the IRS believe that such a contract is not a commodity futures contract of the kind envisioned by Congress when it enacted section 1256. (We don’t think the IRS will view Nadex binary options as a futures contract; therefore, will view it as a NPC.)

• Definition of Regulated Futures Contract (RFC)
Section 1256(g)(1) defines a regulated futures contract as “a contract (A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) which is traded on or subject to the rules of a qualified board or exchange.” The apparent breadth of section 1256(g)(1) has raised questions in the past as to whether a contract other than a futures contract can be a regulated futures contract. (The IRS is trying to clean up some loose definitions in the past.)

Trading binary options on Nadex
The derivatives exchange based in the U.S. is the North American Derivatives Exchange (Nadex) which offers retail traders an online trading platform for limited-risk “binary options and spread contracts” based on stock indices, commodities, forex and financial events. Make a speculation and hold it through expiration for an “all or nothing” pay off, which some pundits say is akin to making a bet. Or trade the contract before expiration to cash it in at the current market price fluctuating on Nadex. Most Nadex contracts settle in one hour or one day, and the rest settle in a week or longer.

There is active trading on the Nadex platform/exchange similar to trading platforms on securities and futures exchanges. A trader may not notice much difference, but there are important differences in regulation and tax treatment.

Nadex issued 1099Bs using Section 1256 treatment
For tax years 2004 through 2013, Nadex issued direct members a Form 1099-B reporting Section 1256 tax treatment.

As pointed out in our first blog in this series, Nadex is a domestic board of trade — a category 2 qualified board or exchange (QBE) since it’s a CFTC-regulated “Designated Contract Market”. But that alone is not enough; Nadex binary options still must meet the definition of Section 1256 contracts. In February 2014, Nadex emailed us the following statement: “Nadex has recently been advised by staff of the Commodity Futures Trading Commission that its instruments are considered ‘commodity options’ categorized as ‘swaps.’”

We feel that Nadex binary options probably don’t qualify for Section 1256 
Nadex binary options don’t seem to meet the definition of inclusion in Section 1256 as either a regulated futures contract or a nonequity option, and they seem to meet the definition of exclusion from Section 1256 as a swap contract.

Nadex binary options don’t meet the definition of Section 1256 for “regulated futures contract” (RFC). A Nadex binary option requires full payment in advance — it’s not collateral — and there is no withdrawals based on MTM. Nadex binary options are prepaid bets. There seems to be consensus on this point.

Nadex binary options probably do not meet the definition of Section 1256 for “nonequity options” as they don’t seem to meet the definition of “options” in the tax code (Section 1234a) (see further discussion below). We haven’t seen a private letter ruling, tax opinion letter or tax research supporting a nonequity option argument for Nadex binary options.

Nadex binary options probably are excluded from Section 1256 as swap contracts. The CFTC said they are “commodity options” categorized as swaps. Dodd Frank law enacted Section 1256(b)(2)(B) into law effective July 2011. Section 1256(b)(2)(B) excludes swap contracts from Section 1256 tax breaks. Proposed regs for Section 1256(b)(2)(B) are not yet effective and they define swaps based on the IRS definition of “notional principal contracts” (NPC). NPC normally require two payments whereas Nadex binary options have one payment. The difference between one versus two payments does not seem material to us.

The IRS proposed regulation excludes all notional principal contracts (swaps) from Section 1256. But, the IRS received many comments arguing that exchange-traded swap contracts, as opposed to off-exchange OTC swaps, should not be excluded since the commenters believed they had Section 1256 tax treatment before Dodd-Frank. Until the final regulation 1256(b)(2)(B) is issued, we won’t know the final outcome. Nadex binary options are exchange-traded swaps, not OTC. Even if in final IRS regulations Nadex binary options are not excluded as exchange-traded swaps, they still must qualify as a non-equity option and we don’t think they do.

We suggested to Nadex that they file for a private letter ruling to support using Section 1256 on 1099Bs for Nadex binary option transactions.

CFTC definition of “option”
The Nadex email says the CFTC referred to their binary options as “commodity options.” They are bets that rise or fall based on an underlying market or financial event, they are based on option pricing models and they trade like options. Before Dodd-Frank, the CFTC could use this narrow definition. The issue of whether binary options are “options” in accordance with CFTC regulation came up in court in 2013. As reported on Goodwingaming, “The binary option trading platform Banc de Binary currently faces a civil lawsuit in the District of Nevada brought by the CFTC for allegedly violating ‘the Commission’s ban on trading options off-exchange.’ The regulatory authority of the CFTC covers ‘options’ which are adroitly defined as ‘transaction(s) .. . held out to be of the character of, or . . commonly known to the trade as option(s).’” The defendant argued their binary options are not options per the CFTC’s full regulatory definition. The CFTC argued that only the first part of the definition counts: “What makes an option an option is the first of these three components — price speculation.” This sounds similar to Nadex’s options pricing.

“In a parallel lawsuit brought by the Securities and Exchange Commission, Judge Robert Jones (District of Nevada) agreed, explaining: With a binary option, . . . the purchaser receives neither the stock itself nor the right to purchase the stock in the future. Binary options are in substance pure gambling bets. . . . Binary option givers and buyers do not purport to trade interests in securities any more than tellers and gamblers at a racetrack purport to trade interests in horses. . . . The Court simply cannot agree that a contract under which the purchaser has no putative right to obtain the security is an ‘option.’”

IRS definitions of “option” is different
The tax code definition of an option sounds like the SEC argument rather than the CFTC argument in the above court cases. The main problem with saying that a Nadex binary option is a nonequity option for Section 1256 is that there is no right to receive property, or alternatively to receive cash equal to the right to receive property (in the case of a cash settled option).

Tax court cases and very limited IRS guidance
Industry professionals equate binary options with “digital options” and “paired options.” These terms came up in just a few tax court cases, which are about tax avoidance, not options. We don’t see any statements in these cases that indicate the court viewed binary options as true options. Section 1256 tax treatment is not used on binary options in any of these tax court cases. These cases do not connect the dots for supporting a Section 1256 position.

In The Markell Company, Inc. v. Commissioner, TC Memo 2014-86, “taxpayer/partner wasn’t entitled to multimillion dollar loss on complicated basis-inflating paired options/Son of BOSS (tax shelter) transaction using newly formed LLC/partnership.”..”Paired Options. The paired options in this case consisted of short and long European digital call options. These cash-or-nothing options can be valued by multiplying the present value of the cash payoff amount by the probability calculated from the Black-Scholes-Merton (BSM) model that the digital option will be in the money at the expiration date.” While Markell used paired options, the case is about tax avoidance transactions based on purposely mispricing paired options. (This case does provide tax guidance for treating binary options based on currencies as Section 988 ordinary gain or loss. There is a connection between the binary option and the underlying instrument it’s meant to mimic in price.)

In Douglas R. Griffin, (TC Memo 2011-61), “HydroTemp timely filed a return for the tax year ending June 30, 2003, reporting a $7,524,153 long-term capital gain from the asset sale to Pentair and a $7 million short-term capital loss from the sale of binary options (i.e., options in which the payoff is structured to be either a fixed amount of compensation if the option expires in the money or nothing at all if the option expires out of the money). .. IRS’s position. IRS disallowed HydroTemp’s losses from its claimed binary options sale.” In this case, the court accepted the binary option transactions as legitimate and the taxpayer won the case. (This case may provide tax guidance for treating the sale of binary options before they expire as being capital gain or loss on realized transactions; however, the IRS attorneys did not seem to have focused on the tax treatment of the options, but simply questioned the legitimacy of the transaction . When terminating a binary option short of expiration, perhaps capital gains and loss treatment is applicable, as discussed below.)

In an IRS Coordinated Issue Paper explaining IRS Notice 2003-81 (Tax Shelters), ,the IRS discusses “option premium” on binary options. “Gain and loss on options is accounted for on an open transaction basis. As explained in Notice 2003-81, the justification for open transaction treatment is that the gain or loss on an option cannot be finally accounted for until such time as the option is terminated. Thus, premium income is not recognized until an option is sold or terminated. Rev. Rul. 58-234.… explains that this is the treatment for the option writer because the option writer assumes a burdensome and continuing obligation, and the transaction therefore stays open without any ascertainable income or gain until the writer’s obligation is finally terminated. When the option writer’s obligation terminates, the transaction closes, and the option writer must recognize any income or gain attributable to the prior receipt of the option premium.” This should be the rule for the receipt of option premium whether the instrument is truly an option or not. This IRS guidance seems weak for building a case that a binary option is treated as a true option and therefore a nonequity option in Section 1256. (In Notice 2003-81, the binary options discussed were based on foreign currency transactions and Section 988 ordinary gain or loss on realized transactions applied by default on the binary options, not Section 1256.)

Tax compliance and planning
In general, we think binary options start off with ordinary gain or loss treatment. In Highwood Partners v. Commissioner (133 TC 1, 2009), digital options based on currency transactions were Section 988 ordinary gain or loss treatment. If you have a Nadex 1099B reporting Section 1256 treatment from binary options based on currencies, you should use Section 988 ordinary gain or loss treatment and not Section 1256, thereby overriding the 1099B.

Swap tax treatment calls for ordinary gain or loss tax treatment, too. Ordinary losses can generate large tax refunds since traders are not subject to the $3,000 capital loss limitation. Caution, large ordinary losses without qualification for trader tax status (business treatment) can lead to some wasted losses and wasted itemized deductions; as those ordinary losses are not a capital loss carryover or a net operating loss carryback or forward.

When a trader sells a Nadex binary option (not based on currency) before expiration, the IRS may view the proceeds as a “termination payment” on the sale of a capital asset, rather than a “period payment” on a swap contract. Normally, termination payments on capital assets are capital gains.

Tax attorneys Mark Feldman and Roger Lorence, and Darren Neuschwander, CPA contributed to this blog. 

Bitcoin is not reported on 2013 FBARs

June 6, 2014 | By: Robert A. Green, CPA

Bitcoin investors store bitcoin on foreign exchanges in countries like Estonia, Russia and elsewhere. Do they have to file bitcoin holdings outside the U.S. on 2013 FBARs due June 30? The IRS just said no.

The following are excerpts from Thomson Reuters/Tax & Accounting’s “IRS official: taxpayers don’t have to report virtual currency on 2013 FBARs”:

“During a recent webinar, an IRS official stated that for purposes of the current filing season, taxpayers aren’t required to report virtual currencies on a Report of Foreign Bank and Financial Accounts (FBAR) with the U.S. Treasury. However, although this previously disputed matter is settled for the present, he stated that this position may well be subject to change.”

“Virtual currency isn’t subject to FBAR reporting … for now. During a recent IRS webinar titled “Reporting of Foreign Financial Accounts on the Electronic FBAR,” Rod Lundquist, Senior Program Analyst in IRS’s Small Business/Self Employed (SB/SE) division, stated that for purposes of the current filing season (i.e., for 2013 FBARs due later this month), taxpayers aren’t required to report Bitcoin on an FBAR. However, he cautioned that IRS is continuing to analyze virtual currency and that this policy could very well change going forward.

The issue of whether Bitcoin is subject to FBAR reporting has been widely debated among the financial and tax online community. One view is that, unless a taxpayer can prove that their bitcoins are within the U.S. (a potentially tricky proposition), then their owner would be required to file an FBAR if his holdings exceed $10,000. However, others question whether a Bitcoin account is truly a “financial account” with a “financial institution” for purposes of the FBAR rules-and, despite the IRS official’s recent pronouncement, these questions are still unanswered.”

Can business traders apply Section 475 elections to bitcoin trades?

May 21, 2014 | By: Robert A. Green, CPA

At the May 9 American Bar Association (ABA) meeting, tax attorneys asked the IRS about bitcoin. According to Tax Analysts coverage of the meeting, Jo Lynn Ricks of Deloitte Tax LLP said the IRS guidance didn’t answer the question of whether a virtual currency could be a commodity, adding that if it is a commodity, dealers and traders could elect mark-to-market treatment under section 475(e) and (f).

“If you have something that trades through a futures contract, then it could be a commodity through the [Commodity Exchange Act],” she said. Bitcoin futures are traded on an exchange called ICBIT, creating the potential for virtual currencies to meet that broader definition of commodity, according to Ricks.

In its guidance, the IRS labels bitcoin an “intangible asset,” but it doesn’t go as far as labeling bitcoin a commodity. The sale of an intangible asset, commodity or security brings capital gains or loss treatment. The sale of a commodity futures contract traded on a U.S. commodities or futures exchange means lower 60/40 tax rates under Section 1256.

Business traders electing Section 475 have ordinary gain or business loss treatment on Form 4797 Part II. We generally recommend business traders elect Section 475 on securities only, so they can retain lower 60/40 tax capital gains tax rates on futures (considered “commodities” in Section 475). Our tax attorney Mark Feldman suggests that to deal with bitcoins, the election language be changed so that it applies “for securities and for those commodities which are not eligible for Section 1256 treatment.”

IRS Guidance On Bitcoin Transactions

March 25, 2014 | By: Robert A. Green, CPA

The IRS just issued bitcoin guidance stating that it is considered property, not a currency.

That’s good news for taxpayers with huge gains on using, investing or trading bitcoin, since it receives capital gains treatment and if they held it over one year, the lower long-term capital gains tax rate applies.

Conversely, it’s bad news for those with large losses, with the recent price of bitcoin dropping significantly. According to the IRS guidance, bitcoin does not receive Section 988 ordinary loss treatment, which is unlimited; instead, it’s capital-loss treatment is limited to $3,000 per year.

The IRS guidance stresses a point — widely overlooked by many taxpayers — that using bitcoin to purchase an item or service triggers capital gain or loss recognition reflecting appreciation or depreciation of bitcoin. Compare the market price on the date bitcoin is used to make a purchase vs. the market price on the date you acquired that bitcoin, and the difference is a capital gain or loss on property. Few people or companies have filed Form 1099s on these transactions, as may be required, and taxpayers will have to scurry around to figure their cost basis and sales proceeds on each purchase where they used bitcoin as a digital currency. See the example of buying a cup of coffee with bitcoin in the Bloomberg article Bitcoin Is Property Not Currency in Tax System, IRS Says. The WSJ articles IRS Says Bitcoin Is Property, Not Currency and Q&A: The New IRS Rules on Bitcoin are good too.

Having to report a capital gain or loss on each purchase using bitcoin will have a chilling effect on bitcoin reaching its goal to be a widely used digital currency. Who wants to spend 30 minutes or more figuring out their capital gain or loss for a simple $3 cup of coffee? And who wants to risk getting audited by the IRS over bitcoin tax reporting to boot?

See the IRS Notice 201421 which includes many good FAQs that may strike a cord with taxpayers.

Bitcoin is a hot commodity, but how is it taxed?

December 3, 2013 | By: Robert A. Green, CPA

Buttressed by an Internet craze, the price of bitcoin has skyrocketed this past year from $17 to over $1,200. Pundits expect significant price volatility in 2014 as well.

While the Federal Reserve gave tacit approval, stating “virtual currencies like bitcoin have legitimate uses and should not be banned,” the IRS has not yet issued tax guidance. Despite the lack of guidance, income from bitcoin transactions must be reported.

What’s the bitcoin tax treatment for traders?
There are two possibilities how bitcoin should be treated for tax purposes: either it is an (1) intangible asset, or (2) a foreign currency. The problem with saying that it’s a currency is that it is not issued by a government, and traditionally currencies are legal tender issued by governments. In California Bankers Assn v. Shultz, the Supreme Court stated (in a non-tax context): “‘Currency’ is defined in the Secretary’s regulations as the “coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.” The IRS has not said its opinion, but both Canadian and Swedish tax authorities are treating bitcoins as an asset. Also, the German Finance Ministry says bitcoin is not classified as e-money or a foreign currency, but is rather a financial instrument under German banking rules. It is our sense that unless Congress enacts legislation to treat bitcoins as a foreign currency, the IRS will treat bitcoins as an asset.

If you buy bitcoin for purposes of appreciation and then sell it, then if (1) bitcoin is an asset, you will have capital gain and loss, and (2) if bitcoin is a foreign currency, then under Section 988 you will have ordinary income and loss.

Is bitcoin a commodity?
There is no definition in the Internal Revenue Code of “commodity.” Black’s Law Dictionary 342 (4th ed. 1968) defines commodity: a movable article of value that can be bought or sold. A bitcoin is not movable property, so arguably it’s not a commodity. But at the Senate hearing, academics and financial industry players warned that bitcoin could be regulated as a commodity if market volatility continues. Such financial regulation may or may not impact the tax treatment.

Most bitcoin investors and traders will prefer capital gains tax treatment
After the astronomical rise in bitcoin this past year, most investors and traders may prefer capital gains and loss tax treatment. Consider this example: An American investor bought bitcoin at $17 just over 12 months ago and he sold it recently for $1,200. Is he entitled to significantly lower long-term capital gains tax rates of up to 20% in the top bracket and up to 15% in the second top bracket? That’s 20% lower than the top ordinary rates of 39.6% and 35%.

In this example of incredible appreciation, investors and traders will prefer that the IRS views their bitcoin transactions as trading in a commodity or other capital asset held for price appreciation. As long as the investor did not acquire the bitcoin as part of his business or for personal reasons this tax treatment seems safe to deploy on 2013 tax returns — until the IRS says otherwise.

It’s important to also consider tax treatment for commodities sold in a business vs. trading in commodity futures contracts. A farmer sells his wheat and reports ordinary gain or loss treatment in his trade or business. Conversely, a commodity futures trader holds “capital assets” subject to capital gain or loss treatment. Regulated futures contracts benefit from lower 60/40 capital gains tax rates (60% is a long-term capital gain — even on a day trade — and 40% is ordinary tax rates).

Say a trader’s regulated futures contract expires and he takes delivery of bushels of wheat. If he sells those bushels of wheat in less than 12 months, he receives short-term capital gains treatment, not ordinary gain or loss treatment or lower 60/40 tax rates since the bushel does not qualify as a Section 1256 contract.

Can bitcoin traders use ordinary loss tax treatment in Section 475?
What goes up fast and irrationally may also go down fast and irrationally. New investors may wind up with big trading losses and they may wish for ordinary loss treatment instead of $3,000 capital loss limitations and large capital loss carryovers.

As the bitcoin trading market expands, some bitcoin traders may be able to achieve trader tax status (business treatment) on trading that asset class. It is not clear whether they can make a Section 475 MTM election for trading bitcoin to have business ordinary gain or loss treatment. Section 475 allows “Traders in Securities and or Commodities” to make the election. The term “commodities” above really refers to trading Section 1256 contracts or regulated futures contracts; Section 475 does not seem to include bitcoin. However, if bitcoin becomes regulated as a commodity, it may qualify for Section 475 treatment.

A potential case for using Section 988 ordinary gain or loss treatment
If you don’t qualify for trader tax status in bitcoin, perhaps you can convince the IRS to respect the Fed’s label of “virtual currency,” and argue your bitcoin trades qualify for application of Section 988 (foreign currency transaction) ordinary gain or loss treatment.

Section 988 is the default tax treatment for spot forex trades, which is a huge trading marketplace. Spot forex traders write off trading losses in full as ordinary losses on line 21 of Form 1040 (Other Income). If they have trader tax status, they use Form 4797 Part II business ordinary loss treatment, which feeds into Net Operating Loss (NOL) calculations.

Section 988 allows forex traders and investors, but not manufacturers and other operating businesses, to file a contemporaneous internal opt-out or capital gains election. Many forex traders file a capital gains election and navigate their way into lower Section 1256g lower 60/40 tax rates, too. Section 988 does not allow a capital gains election on holding physical currency and that would apply to holding bitcoin, too if Section 988 were to apply. Section 988 rules for forex traders are complex and beyond the scope of this article.

Bitcoin as a digital currency
In general, American vendors accepting bitcoin as a digital currency in their trade or business should report bitcoin transactions as they would with a foreign currency. Simply translate the foreign or digital currency back into U.S. dollars on the date of receipt. There are no grounds to defer recognition of these transactions simply because it’s in bitcoin.

Holding bitcoin in your business
What happens if a trade or business decides to hold bitcoin for appreciation after acquiring it in a regular business transaction? Is it ordinary gain or loss from holding a commodity in your trade or business, or a capital gain or loss from holding onto a commodity or capital asset for appreciation? Both can be the case and it depends on intention, facts and circumstances.

In the earlier example, the farmer stockpiles wheat in a grain elevator, perhaps waiting for higher prices. The farmer may also hedge wheat prices in the futures market. Under the “hedging rule,” the wheat farmer still has ordinary gain or loss on storing and hedging wheat.

Also, consider the example of a manufacturer who holds foreign currency reserves for later use in foreign markets or for appreciation. The manufacturer also may hedge his foreign currency in the futures market. Like the farmer, the manufacturer has ordinary gain or loss on all these transactions.

An Internet vendor is not a commodity farmer of bitcoin and it’s conceivable that he could segregate bitcoin as a commodity or capital asset held for investment.

Bottom line
Bitcoin is a hot asset for traders and investors and you should learn the tax rules before you plow your money in. If you acquired bitcoin in your business, make sure you reported your sale transactions correctly.

Swaps Tax Treatment Confusion Cleared Up With Fin Reg

July 22, 2010 | By: Robert A. Green, CPA

Forbes

The “Restoring American Financial Stability Act of 2010” — also known as “Fin Reg” — signed into law on July 21 moves many derivative contractors from the private marketplace to clearing on futures exchanges. In Section 1601 of the bill, Congress makes it crystal clear this movement isn’t like trading and it doesn’t afford these derivatives contracts the regulated futures contract tax treatment in Section 1256.

Swap contracts – a form of credit insurance – were at the center of the credit crisis. AIG wrote far too many of these swap contracts (pocketing the premium) and lacked sufficient capital to cover its eventual credit losses at the height of the financial panic. Regulators lacked transparency since swaps were private derivatives contracts. 

Fin Reg addresses these problems by moving many derivative swap contracts into clearing on futures exchanges to provide market-based transparency of pricing and terms and normal exchanged-based margin and leverage rules. However, in moving to futures exchanges, Congress did not want to reward swap contracts with the lower 60/40 treatment in Section 1256. 

The new law amends Section 1256 to broaden the list of contracts that are barred from the definition. Section 1256 contracts include: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. Under pre-Act law, the term Section 1256 contract doesn’t include securities futures contracts or options on such a contract unless the contract or option is a dealer securities futures contract. 

Law change
For tax years beginning after July 21, 2010 all of the following also are excepted from the definition of a Section 1256 contract: any interest-rate swap, currency swap, basis swap, interest-rate cap, interest-rate floor, commodity swap, equity swap, equity-index swap, credit default swap, or similar agreement. (Code Sec. 1256(b), as amended by Act Sec. 1601. You can find Section 1601 – Title XVI – Section 1256 Contracts on the last pages of the bill.) 

The Conference Report says the change addresses the recharacterization of income as a result of increased exchange trading of derivatives contracts by clarifying that Code Sec. 1256 doesn’t apply to certain derivatives contracts transacted on exchanges. 

Leading tax attorney for investment-management businesses Roger Lorence emailed me, stating that “Swaps were not 60/40 under prior law. The new law clarifies that their status is not 60/40. Leading experts have expressed their views that there was confusion in the marketplace about the treatment of swaps cleared by clearing arms of exchanges, although the swap contracts themselves were not traded on a qualified board or exchange (traded on a QBE is a requirement for 60/40 treatment). There is a difference between clearing and trading — trading means a designated contract market for that contract has been approved by the CFTC and swaps are not eligible for designation as a contract market (there can’t be trading in a swap). No contract that legitimately is 60/40 now loses 60/40 under this bill. The amendment is designed to foreclose aggressive taxpayers from taking the position that swaps are 60/40.”

Thanks Roger, this clarifies my question about traders gaining a new opportunity to trade these derivatives contracts – they don’t get this opportunity. They can gain from the transparency on the exchange clearing.