Category: Cryptocurrencies

Taxation of Cybercurrency Exchanges

Internal Revenue Code Section 1031 defers taxation involving exchanges of like-kind property held for investment or business. If a taxpayer traded one parcel of real estate for another, the transaction is, in general, tax-free. Congress changed Section 1031, commencing January 1, 2018, applying it solely to real estate. But what about exchanges of cryptocurrency prior to January 1, 2017; did they qualify for tax-free treatment? Tax experts reasoned that a swap of one cryptocurrency for another probably fell within Section 1031 and was not taxable.

IRS Memorandum

On June 8, 2021, IRS published a Memorandum (Number 2021124008, appended to this article) stating that exchanges involving swaps of Bitcoin, Litecoin, and Ether were not covered by Section 1031 because of differences in overall design, intended use and actual use. This Memo should apply to practically all pre-2018 cybercurrency swaps. Note: although the Memo is not law and the courts are not bound by it, it is followed by IRS so expect audits of pre-2018 cryptocurrency exchanges.

While the like-kind exchange rules are broadly interpreted for real estate, the same is not true for other assets. IRS has ruled that gold is not like-kind to silver and a bull is not like-kind to a cow. Cybercurrencies are intangible assets and the exchange rules for intangibles are much more restrictive than real estate; thus, successfully challenging the Memo could be problematic, if not futile.

Amending Your Return

So, should you amend your pre-2018 tax return to report cybercurrency exchanges? The answer may depend on whether the applicable statute of limitations for tax assessments has expired. The usual rule is three (3) years from the date the return was filed, so assessments for the 2017 tax year (assuming the return was filed on the due date, April 15, 2018), would have expired on April 1, 2021 (or will expire on October 15, 2021 if an extension was filed). There is a special six (6)-year statute of limitations when, in general, taxpayers fail to report more than 25% of their gross income1. Unless the exchanges were properly reported on Form 8824 or IRS was otherwise adequately notified of the transactions, expect the six (6)-year statute to apply.

As a practical matter, taxpayers claiming exchange treatment would have filed Form 8824 so the 3-year statute should apply for pre-2018 exchanges2. Note; If there was tax fraud with the return, there is no statute of limitations for assessment.

Conclusion

Taxpayers who timely and accurately reported their cryptocurrency exchanges for tax years prior to 2018, the statute of limitations for assessment will have expired (or will expire on October 15, 2021 if the return was on extension). If they failed to report their exchanges and the omitted gross income amount exceeding 25% of the income reported, the special six (6)-year assessment period applies, which means IRS could assess back taxes, penalties and interest for tax years 2015, 2016 and 2017.


1 Example: If a taxpayer files a return reporting $100,000 of gross income the omitted income must be at least $25,000 for the six(6)-year statute of limitations to apply.

2 The 6-year statute does not apply when IRS has been adequately apprised of the potential omitted gross income and filing Form 8824 puts IRS on notice of the exchange transactions.

IRS is Gunning for Unreported Cryptocurrency Transactions

Note: For more information on cryptocurrency taxation and tax planning strategies, purchase my Tax Brief for just $9.95: Cryptocurrency Income Tax Planning: A Tax Brief

Warning Letters:

It’s been all over the news that IRS mailed 10,000 letters to potential cryptocurrency participants, warning them that IRS suspects they have engaged in cryptocurrency transactions (IRS uses the term “virtual” currency) and reminding them to report gains and losses. IRS has received substantial information from Coinbase, which was obligated under court order to turn over transaction records. Coinbase subsequently supplied detailed information on more than 14,000 customers. Using its success against Coinbase, IRS is targeting other on-line exchanges with similar lawsuits and the court have thus far sided with the government.

If you receive an IRS warning letter, treat it very seriously. One letter asks you to sign under penalty of perjury that the response information is correct.1 It unwise to reply without first obtaining professional advice because signing under penalty of perjury could lead to criminal perjury charges if IRS already has or obtains information contradicting your written declaration.

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IRS Audits:

It is now IRS standard audit practice to inquire about cryptocurrency investments. Remember that IRS may already have this information and submitting a false response could lead to criminal charges or severe civil (non-criminal) penalties.

New Tax Return Question:

Starting tax year 2019, Form 1040 (Individual Income Tax Return), Schedule 1 poses the following question: At any time during 2019. did you receive sell send, exchange or otherwise acquire any financial interest in any virtual currency?

1]  The three letters are attached to this article.
2]  See the attached tax form.

You must answer that question “yes” or “no” under penalties of perjury. If you did not have transactions in 2019, there’s nothing to report and you can safely answer the question “no.”

If you answer the question “yes” and report your taxable cryptocurrency transactions, there is no reason to believe IRS will automatically audit you. If you answer the question “no” and IRS has information to the contrary, you could land in big trouble; if you intentionally failed to report your cryptocurrency transactions, in addition to taxes, penalties [3] and interest, you could be staring at federal criminal perjury or tax evasion charges. Note: failing to respond when you have significant cryptocurrency transactions is considered the same as marking the box “no.”

Conclusion:

IRS is aggressively pursuing on-line exchanges for information and forcing taxpayers to disclose cryptocurrency transactions with written responses made under penalties of perjury. If you have not reported your cryptocurrency transactions, it behooves you to get into compliance as soon as possible. Deceiving IRS by falsely claiming you do not have any transactions can lead to civil fraud penalties, perjury charges or possibly criminal tax evasion charges, depending on the severity of the situation.

[3] The typical negligence penalty is 20% of the tax due,; however, if there was fraud, the penalty can be 75% of the taxes due. Misleading IRS by falsely checking the box no is an indicator of fraud.

Announcing a New Tax Brief: Tax Planning for Cryptocurrencies

Introduction

I’ve written a Tax Brief discussing long-term U.S. tax planning for cryptocurrency investors. Every such investor must be fully aware of the potential tax traps and planning opportunities involving cryptocurrencies.  My Tax Brief runs the gambit from absolute disaster and financial ruin to extremely favorable taxation, including in some cases, cryptocurrency gains without federal or state taxation. Here are excerpts from my Tax Brief – you decide whether spending $9.95 for this information is worth it:

Beware – Major Tax Trap!:  Trading in cryptocurrencies carries a huge tax risk!  Losses from one calendar year cannot be carried back to offset gains from prior years.  This drawback often occurs with day traders of securities and others who do not understand how the capital gain and loss rules work.  Consequently, taxpayers can generate a huge tax without retaining sufficient assets to pay it.

Cryptocurrency As Payment For Goods or Services:  Receiving cryptocurrency as payment creates ordinary business income, but the asset is subject to capital gains and losses, so the cryptocurrency recipient has ordinary income as to the fair market value of the product being sold or service performed, whether or not the cryptocurrency thereafter increases or decreases in value.

The Lesson: Be cognizant of your gain or loss position and make sure you sell loss positions by the end of the calendar year to offset gains during the year.  Selling the loss positions in the subsequent year can lead to disaster because you cannot carry them back.  For merchants and service providers, make sure your cryptocurrency transactions comprise a fraction of your business transactions or sell them immediately to protect yourself against a devaluation; remember, your income is based on the price of the product or service sold and not the subsequent value of the cryptocurrency.

Tax-Planning Concept:  A C corporation is a separate taxpaying entity.  Prior to 2017, C corporations were taxed at a maximum federal rate of 35%; the 2017 tax act lowered the corporate tax to 21%.  This compares favorably to the highest federal individual tax rate of 38.8%.  However, if a C corporation makes dividend distributions to individual taxpayers, the dividends are taxed at capital gains rates, so there is a potential double tax on corporate income, once at the C corporation level and again at the shareholder level.  If the goal is to invest and reinvest in cryptocurrencies (or any other investment asset, such as stock or securities) for the long term, the initial savings in taxes by using a C corporation should outstrip the potential for a shareholder-level tax down the road.  The earnings of the corporation may be used to fund family real estate ventures or other investments, without triggering a tax on dividends.  Note: with careful planning, state income taxes can be avoided as well.  A C corporation can protect you against individual liability if disaster strikes in the form of gains in one year and losses in a subsequent year.

Conclusion:  Savvy taxpayers should consider investing through a C corporation to reduce taxation and for personal asset protection.  At a minimum, investors need to thoroughly understand how capital gains and losses work, since IRS considers cryptocurrency property, an asset, and not the equivalent to actual currency.  Thus, every transaction with cryptocurrency is taxable.