Cryptocurrency and “Like-Kind” Exchanges
There is quite a bit of information online regarding like-kind treatment and cryptocurrency. Some of is it very good, and a lot of it is very very bad. This article is deigned to help you understand what is and isn’t allowed when it comes to cryptocurrency transactions.
What are like-kind exchanges?
Like-kind exchanges are governed by Section 1031 of the Internal Revenue Code, and allow for deferring or postponing the recognition of capital gains when replacing one asset with another of property of similar nature, character or class. This is commonly used in real estate transactions.
What does the law say about like-kind and crypto?
The Tax Cuts and Jobs Act of 2017 made substantial changes to how like-kind exchanges are done. Effective 1/1/18, 1031 exchanges are restricted to real estate only. So the IRS has made it clear that coin to coin exchanges are not under the 1031 rules. Prior to 12/31/17, the IRS has never specifically stated whether or not 1031 exchanges apply to cryptocurrency. Some view this new ruling as proof that the IRS never intended to allow them, while others view is a implied permission to do a 1031 exchange on crypto in 2017.
So where does that leave us?
Without clear guidance from the IRS or tax courts, we are left to try and interpret the rules on our own. What we do know is how the IRS treated similar assets from a historical perspective. Because we know that the IRS treats cryptocurrency as property, the most analogous investment asset we can look at is precious metals. Historically, some precious metals were allowed like kind treatment and most were not. The following were not allowed to take 1031 treatment: Numismatic coins to Bullion coins, coins with different metal contents, gold to silver (etc), and bullion bars to bullion coins. Numismatic coins to other Numismatic coins of the same metal, bullion bars to other bullion bars of the same metal and bullion coins to bullion coins of the same metal were allowed.
So what does this mean for crypto?
This means that most crypto to crypto transactions are not allowed 1031 treatment, and the rest are going to be an uphill battle. We can safely reason that BTC to ETH is not like-kind as Bitcoin and Ether have very different purposes. BTC and BCH gets closer, but with the difference in block size it is still unlikely that they would qualify. ETC and ETH might be valid, but it’s hard to say how the court will interpret it.
I still want to do a like-kind exchange anyway
So if you still want to attempt a 1031 exchange on crypto, here is what you need to do. First of all, you are taking an aggressive position on a tax return, and that needs to be disclosed to the IRS on form 8275. Failure to do this will leave you potentially subject to penalty. Then you need to fill out a form 8824 for EACH TRADE. This is the only way to legally complete a 1031 exchange. You can’t just ignore the trades in the middle and only report cashing out in fiat. You have to know and track the cost basis of each transaction.
What if I ignore the trades in the middle?
Lets say you start with $1000 worth of ETH. The ETH goes up in value to $2000, and you buy $2000 worth of DOGE with it. The DOGE goes to the moon and becomes worth $10000. You use it to buy $10000 worth of XRP. XRP then crashes to $500 and you decide to cash out. You convert it to $500 worth of ETH and send it to Coinbase and cash out to USD.
So under the standard rules, you have 5 transactions:
- $1000 USD to ETH (not taxable or reportable)
- $2000 worth of ETH to DOGE ($1000 gain)
- $10000 worth of DOGE to XRP ($8000 gain)
- $500 worth of XRP to ETH ($9500 loss)
- $500 worth of ETH to USD (no gain or loss, but required to report)
So after all that, you have a $500 loss ($1000 + $8000 – $9500). If you theoretically executed a like kind exchange, you would also get the same net result, -$500. But lets say you ignore all the trades in the middle. You start with $1000 ETH and end with $500 ETH, so you again have a $500 loss. But, since you never reported the other trades to the IRS, if they find out about them, they will tax you as if you had 0 basis on all of them. So instead of the $500 loss, you would have:
- ETH $1000 basis, $500 sale ($500 loss)
- DOGE $10000 sale, no basis ($10000 gain)
- XRP $500 sale, no basis ($500 gain)
So now you have a total gain of $10,000, and the burden of proof is on you to convince the IRS you should have had an overall loss.
This is all assuming you close the position in the same tax year. If you cross over a calendar year, the situation becomes even more complicated.
But how is the IRS going to find out?
The standard statute of limitations is 3 years. If you never file, the SoL never starts. If you substantially understated your position, the Statute of Limitations becomes 6 years. If the IRS determines your intent to be fraudulent, there is no SoL. 3-6 is a very long time in the world of crypto. While exchanges don’t report information to the IRS currently, it is very likely they will before the SoL runs out. At that point it is easy work for the IRS to match the transactions on the return to the information they got from the exchange.
Will you do my 1031 exchange?
No. Based on the above, I feel it is too aggressive of a position to take on a tax return. You will need to be willing to litigate the argument in court, the cost of which will likely cost more than the tax savings you realized by doing a like-kind exchange. Coupled with knowing that as of 2018 there is no ambiguity in 1031s, it does seem to be a prudent position to take.