Review of 1031 Exchange Application to Cryptocurrencies
As we start this new year (and as the tax realities of 2017 settle in), we have been receiving quite a few questions regarding the tax implications of token sales and cryptocurrency exchanges. Purchasers of tokens and those who have bought and sold various cryptocurrencies over the last year (or earlier) want to know how any gains they have received will be taxed. Moreover, many U.S. taxpayers want to know whether Section 1031 of the Internal Revenue Code (“IRC”) applies to exchanges of cryptocurrency, as many cryptocurrency transactions occur between cryptocurrencies themselves (e.g., Bitcoin for Ethereum or Ethereum for some other ERC-20 token) rather than between fiat currencies and cryptocurrencies (e.g., U.S. Dollars for Bitcoin).
What is Section 1031?
As a general rule, if the seller of a piece of “property” sells that property for more than he or she bought it for, that seller will recognize a taxable gain on the sale. IRC Section 1031 provides an exception to this general rule by stating that the seller can, under certain circumstances, postpone paying any tax on the gain if the seller reinvests the proceeds of the sale into a similar type of “property” as part of a qualified “like-kind” exchange.
Do Cryptocurrencies qualify as “property” under U.S. Tax Laws?
According to the U.S. Internal Revenue Service (the “IRS”), the answer is yes. In a 2014 notice, found here, the IRS clearly indicated that cryptocurrencies were to be treated as “property” and not “currency” under U.S. tax laws.
While this notice provided clarity regarding whether cryptocurrencies were “property” for purposes of Section 1031, the question remained whether the exchange of certain cryptocurrencies for other cryptocurrencies (e.g., Bitcoin for Ethereum) would be considered a “like-kind” exchange for Section 1031. To this question, the IRS has never really provided clarity despite several calls for guidance from the accounting and legal communities.
Unfortunately, as of December 22, 2017, this question is now moot.
What happened on December 22nd?
On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law. In the final bill, Congress tweaked the language of Section 1031 by deleting the reference to “property” and replacing it with “real property”. As a result, Congress effectively shut the door on any argument that cryptocurrency holders would have to say that their exchange of cryptocurrencies fell within the meaning of Section 1031.
For those engaged in a heavy volume of cryptocurrency exchanges, this creates a significant accounting and administrative burden to ensure that all taxable gains are reported. There are also many early adopters of Bitcoin and Ethereum who rolled their astronomical early gains into various token sales and may have large tax obligations due to their “paper gains”.
The combination of this burdensome process and the opaqueness of the current cryptocurrency markets will likely drive new regulations to be implemented to formalize the tax reporting process. While this will be much to the chagrin of early crypto adopters, this will likely help to stabilize the markets and calm the currently frantic regulators.
While always good advice, given the particular instability in this regulatory minefield, we highly recommend that you seek the guidance of your accounting and tax professionals for any specific questions regarding the tax treatment of your cryptocurrency holdings and exchanges.
Scannavino Lamb LLP is a boutique law firm based in New York City offering legal and business advice to forward-thinking entrepreneurs, startup companies, and startup investors. Founded by former Big Law lawyers, the firm serves its clients by blending world-class service with entrepreneurial perspective. Check us out at www.scannavinolamb.com.
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