History. Alt coin, sometimes called crypto coin or currency, remained in relative obscurity until Bitcoin’s meteoric rise in price in 2017. This rise in Bitcoin price brought everything about Bitcoin and other alt coins into the public eye. The IRS was slightly ahead of the general public in taking notice of alt coins. As early as March of 2014, the IRS spoke publicly about the tax classification of alt coin. Then, in November of 2016, as Bitcoin’s price inched closer and closer to $1,000.00 per coin, the IRS issued a “John Doe” summons to Coinbase requesting data on all users including the amount each traded and the gains each user realized.
Self-generated Rules. Around this same time alt coin traders began seeking the advice of counsel regarding the trading they had done, the Bitcoin they had received from “mining”, and any gains they had realized over the past six or seven 1 years from alt coin transactions. Prior to November of 2016, without the exposure of publicity and free from any obvious IRS scrutiny, the alt coin trading population labored and burgeoned without any real regulation and as such alt coin traders themselves had no obvious guidance so instead worked only with a set of self-generated, arbitrary principles that were not necessarily supported by traditional tax laws.
Areas of Concern. Now that IRS scrutiny and inquiry has arrived and is escalating (at nearly as furious a pace as the price of Bitcoin), there are three obvious challenges that have arisen in the aftermath of approximately seven years of self-governance:
1. Alt coin traders have considered exchanges of alt coin for other types of alt coin merely as continuations of their initial investment and as such not taxable until they finally convert whatever coin they hold back to fiat currency;
2. The record keeping requirements and substantiation standards of the IRS (which become pivotally important during the audit process) are not met by the data and forms of data provided by most leading alt coin exchanges, and this deficiency is generally not mitigated by the traders’ own documentation; and,
3. Most miners do not realize that the receipt of alt coin in exchange for services is considered taxable compensation under the tax code for both income and self-employment tax purposes.
Over the next three weeks each of these three challenges will be discussed in turn. This first article discusses the application of like-kind exchange rules to alt coin swaps.
AVAILABLE GUIDANCE AND APPLICATION OF LIKE-KIND PRINCIPLES
Formal Guidance. IRS Notice 2014-21 is the only official guidance from the IRS regarding alt coins. The notice was issued in March of 2014 and no subsequent guidance or legislation changes the conclusions in the notice. In essence, the notice classifies alt coin as property. As such, all tax rules concerning property apply to alt coin. This includes a host of rules but perhaps most importantly, 26 U.S.C. 1001, which makes any gain upon transfer or disposition of property a taxable 2 event. Any such disposition or transfer would include exchanging Bitcoin (or any other alt coin) for another type of crypto currency (ex. Bitcoin for Ethereum). The only obvious exception to this general rule is the like kind exchange provision under 26 U.S.C. 1031 (“1031”).
IRC Section 1031. The IRS has not opined regarding the application of 1031 to alt coin swaps or exchanges. The IRS has opined a number of times regarding whether different traditional coins were “like-kind” so as to satisfy the requirements of 1031. 3 Interestingly, the IRS generally focuses on the nature of the value of each coin to determine if the coins are like-kind. For example, the most simplistic comparison involved the exchange of a gold coin for a silver coin 4 wherein the IRS denied like-kind treatment because the value of a gold coin and the value of a silver coin are derived from distinct qualities: one is gold and one is silver and the markets for each precious metal are separate and distinct. Some of the other decisions are more complex and consider the value of the coin as a medium of exchange versus the value of a coin as a collector’s item 5. In general, the IRS looks at the essence of the coin’s value to determine if it is like-kind.
Income Recognition. Taking all of this into consideration, trading alt coin for other alt coin, converting alt coin to fiat currency, or trading alt coin for any other product, service or property, is an income recognition event for tax purposes – you would report your gains or losses on each disposition unless some exception applied. The only apparent exception is 1031. Due to the 2017 tax act, 1031 is no longer even arguably available for exchanges made after December 31, 2017. Regarding pre-December 31, 2017 exchanges, the IRS has not opined about the applicability of 1031 to alt coin exchanges. It would seem the IRS would have a substantial basis for disallowing like-kind treatment of certain more popular exchanges; for example, Bitcoin for Ethereum exchanges. Bit coin and Ethereum are fundamentally different and derive their value from very different underlying processes and purposes. ( See, for example, “Ethereum vs. Bitcoin: What’s the Difference”, Digital Trends, December 27, 2017, Jon Martindale – available at https://www.digitaltrends.com/computing/ethereum-vs-bitcoin/). Also consider Ripple, which may have some similarities to the other two but whose value is derived considerably from its focus on and acceptance by the financial sector as a way of validating payments. ( See, for example, “Bitcoin vs. Ethereum vs. Ripple: Comparing the Cryptos”, Valuewalk, February 16,
2018, Christopher Morris – available at http://www.valuewalk.com/2018/01/bitcoin-vs-ethereum-vs-ripple-comparison/).
Form 8824. Furthermore, note that claiming a 1031 position requires specific mechanics; most notably, Form 8824 must accompany your tax return in the year you make the exchange. Most alt coin traders have likely never filed Form 8824 to report their possible like-kind position.
2017 Tax Act. Finally, the 2017 tax act eliminated the use of 1031 for all exchanges except for real property exchanges. Therefore, without any doubt, 1031 no longer applies to alt coin swaps if it ever did.
CONCLUSION. Under general property tax rules, any exchange or disposition is a taxable event. Any gain from such an exchange or disposition must be reported, and is subject to taxation. Pre-December 31, 2017 exchanges could arguably qualify under 1031 as like-kind exchanges, but the issue has not been formally addressed by the IRS. Based upon a review of prior IRS opinions regarding trading in traditional coins and precious metals, there appear to be substantial barriers to success of the 1031 position. The prospect of successfully arguing for 1031 treatment for alt coin swaps appears bleak. Finally, any exchanges of appreciated alt coin for other property or cash is clearly taxable and is subject to standard reporting requirements.
Alt Coin (Part 2): Record Keeping
1 In August 2008 the domain “bitcoin.org” was registered, Satoshi Nakamoto published “Bitcoin: A Peer-to-Peer Electronic Cash System” in October of 2008, then the public Bitcoin ledger and mining began shortly thereafter in January of 2009.
2 The notice is also clear that receipt of alt coin in exchange for services – such as mining – is compensation and should be reported as such.
3 California Federal Life Insurance Co. v. Commissioner of Internal Revenue, 76 T.C. 107 (1981); see also, Rev. Rul. 79-143, 1979-1 C.B. 264; see also, Rev. Rul. 82-166, Rev. Rul. 74-7, Rev. Rul. 82-96, Rev. Rul. 76-214.
4 Rev. Rul. 82-166
5 California Federal Life Insurance Co. v. Commissioner of Internal Revenue, 76 T.C. 107 (1981).
