[This post is an offshoot of a longer article on crypto assets that I have been working on. This post is for information purposes only and is not legal advice. In particular, especially in this area, tax ramifications may depend significantly on your particular facts and circumstances and you should consult with a tax advisor for legal advice based on your own circumstances.]
While some investors may be thinking turkeys and cranberry sauce, your neighborhood tax advisors are excitedly gearing up for the upcoming U.S. tax return season. And this year especially, with the myriad of changes brought about by the tax reform act, there is a lot of new guidance to be excited about. But the one area that tax advisors (not to mention the IRS) want you to keep an eye on even as you have one eye on your turkey is actually one where there is no new guidance. In fact, there is a lack of guidance, a lacuna of sorts.
It’s an area that exists as a sort of tax frontier and that frontier is Crypto. If you’ve traded in bitcoins or any of the altcoins or host of digital tokens built over blockchain technology during the year or if you are an institution that facilitates such trading, well, welcome to the frontier.
There’s a limited set of FAQs from the IRS issued in 2014 on the tax treatment of convertible virtual currencies like bitcoin (IRS Notice 2014-21), but other than that, nothing. Taxpayers (and by this I mean both investors and the crypto exchanges, brokerages and platforms that serve them) must largely fend for themselves.
The important thing to remember as in all survival situations is: don’t panic. Figure out what materials are available and try to make use of them for the new situation at hand. Tax attorneys like to think of this as applying known tax principles to the unknown. There’s always some risk that you’ll be wrong, and there’ll likely still be gaps. But you begin there.
You undergo a similar process whether you are an investor or a crypto platform or intermediary. And for the rough terrain, depending on where you are, you might seek out a guide. Actually, as you will see, that might not be a bad idea.
Investors probably have it the hardest. They are the ones ultimately responsible for identifying, calculating and reporting crypto gains on their tax returns and paying the tax on them. And the IRS has reminded them, in news releases and on industry panels, that they must. But what are crypto gains?
IRS Notice 2014-21 tells us that certain convertible virtual currencies (CVCs) like bitcoin are treated as property for U.S. tax purposes. CVCs are generally decentralized digital currencies that can be converted into fiat currency (like USD). While the notice covered only CVCs and not other digital assets, property is likely the place you begin for tax analysis.
If you held property as a capital asset and sold it, you would generally recognize capital gain or loss based on difference between the price you sold it for (gross proceeds) and the amount you originally paid for it (your cost basis). Capital gains would generally be eligible for the lower capital gains tax rates, but capital losses (this is 2018 after all and not the 2017 bull run) would first net against capital gains and then offset only $3,000 of other income. This is the straightforward part.
If instead of selling your crypto asset for cash, you traded it for another coin or token, you’d still recognize gain or loss under general tax principles applicable to property. Your gross proceeds in this case is the fair market value of the property received, and your cost basis is the cost basis in the crypto asset you gave up.
Prior to 2018, some investors argued that certain coin-for-coin trades qualified as tax-free like-kind exchanges under IRC section 1031 even though the matter was uncertain. However, the 2017 tax reform legislation has made this point moot for this year: section 1031 tax-free treatment is now restricted only to certain real estate exchanges.
In the world of crypto, the mundane can quickly become esoteric. “Forks” (no, not the fork for your turkey, but fork like a fork in the road) is a prime example of this.
Cryptocurrencies can have “birthing” events; they enter what is called a “hard fork”. A portion of the cryptocurrency’s developer community may opt for a change in underlying blockchain protocol. If this occurs, those on the new protocol and those remaining on the existing diverge and the blockchain splits. At the split or the fork, one “coin” becomes two separate coins. A holder of the original coin prior to the fork would generally retain that coin and also receive the new forked coin. In August 2017, for example, bitcoin forked, and a holder of bitcoin received one new bitcoin cash for each bitcoin held.
Is the new coin received in a fork treated as income? Or is it more like a stock split? Do we allocate basis from the original coin to the old and new coins? Or do we obtain a zero basis in the new coin? These are questions that await guidance.
In absence of guidance, for investors who like to walk on the safe side of the road, they might decide to report the new coin received as income. But safe as this may be, there are practical issues involved: How do we value the coin received? Is it the value of the coin at the exact time of the fork? Is it clear what that price is at that point in time or are there issues with price discovery? And what if a holder (as it happens) is unable to access the forked coin until sometime in the future? Does this affect not only timing of income inclusion but amount (e.g., different pricing at the time investor has dominion and control over the coin)?
This is not a theoretical issue for investors this year. First, how a fork was treated for a prior year (e.g., 2017) would affect the cost basis in any forked coin sold this year. Moreover, as this post is being written (November 2018), bitcoin cash is undergoing its own fork to become bitcoin ABC and bitcoin SV.
The story behind this latest bitcoin cash fork involves a bit of drama and wrangling between the camps supporting each protocol. The drama (from trading of “futures” on a yet non-existing coin pre-fork to the possibility that one camp post-fork might disrupt the other) is likely to create novel tax questions for the unwary investor.
The High Hurdles
Mundane or esoteric, crypto tax issues present a number of other practical hurdles for an investor seeking to pay taxes.
Some are definitional and stem from the paucity of tax guidance in the area. For example, virtual currencies and digital tokens might be treated differently for tax purposes. There are some arguments that while decentralized cryptocurrencies may not be securities for tax purposes, digital tokens depending on their specific terms could be securities. If they are securities, could they potentially be stock or debt or a partnership interest? Each of those classifications has tax very different tax consequences. Moreover, as securities, certain other rules (e.g., wash sales) might apply whereas they would not if the digital asset were not stock or securities.
While investors often rely on tax form instructions for guidance – the existing tax forms make no mention of crypto. Some analysis may end up being very fact dependent – if you held a token, how it should be classified for tax purposes may depend on its particular terms. The issuance might also include such built-in terms as a future conversion of the issued token for another. How do you treat the token not to mention the conversion in your taxes?
There are also other reporting considerations if trading occurs outside the U.S. – such as potential FBAR reporting (for interests in foreign bank and financial accounts) and foreign financial asset reporting under Form 8938, though reporting for crypto on those forms is also uncertain.
At some point, obtaining tax assistance from an advisor may not be a bad idea. Part of surviving in the frontier might mean not braving it alone.
The other big hurdle has to do with information availability – which leads us to crypto intermediaries.
A primary tax issue confronting crypto platforms such as crypto exchanges and brokerages has to do with their obligations to provide tax reports to the IRS and the investor.
In the world of stocks and securities, brokers generally file Forms 1099-B with the IRS to report sales of securities and commodities for cash by customers. These reports include gross proceeds from sales and, for specified securities, the customer’s cost basis. A statement containing the same (and sometimes additional) information is provided to the customer.
This type of information reporting has been lacking in the crypto world. Investors must largely track cost basis themselves. Moreover, for coin-for-coin exchanges, they might also need to track the pricing for coins on the transaction date.
For the 2017 tax year, certain crypto exchanges appeared to have provided Forms 1099-K to certain customers instead. Form 1099-K is in part is used by third party payment processors to report third party network transactions to merchants (think of PayPal reporting on eBay sellers that have received payments through PayPal). Because there is a de minimis threshold for filing Form 1099-K, such reporting would have been limited to customers with more than $20,000 of reportable payments AND more than 200 transactions (except for customers in Massachusetts and Vermont where state rules provided a low $600 threshold). The rationale may have been that they see such customers as selling property and receiving payment for those sales through their network. It is also a way to keep the IRS happy, given that the IRS had previously sued a U.S. crypto platform for customer information.
The question of whether broader Form 1099-B reporting is applicable to some or all crypto assets has been a matter for debate. Form 1099-B generally is required to be filed by a broker for sales of securities or commodities for cash. The IRS has provided no specific guidance on the applicability of Form 1099-B reporting for cryptocurrencies. Potentially, even without new guidance, such reporting might be implicated if bitcoin or other virtual currencies are treated as commodities for tax purposes (some arguments for bitcoin at least). Barter exchange rules might also be implicated in coin-for-coin exchanges, which may also trigger Form 1099-B reporting. None of this is clear.
If tokens are treated as securities such as stock or debt (or a partnership interest), information reporting becomes all the more immediate.
In the end, a crypto exchange, broker or other intermediary will likely need to sit down with their own tax advisors and think through their business from a tax lens – business functions, types of digital assets traded on their platform, nature of customers and payments being made to them. Do they qualify as a broker? A barter exchange? A third-party payment processor? How should the digital assets on their platform be classified for tax purposes?
Such crypto platforms will need to analyze both tax and business risks and requirements. Not the least of these, whether an exchange or broker may be obligated or not, may be their customer’s expectations in the way of tax information.