Investors in Bitcoin and other cryptocurrencies should be celebrating their gains now because in just a matter of days the 1031 tax loophole that’s been a financial benefit for many will be gone under the new tax law. The Tax Reform bill which passed both houses of Congress and was signed into law by President Trump last week eliminates the exemption for “like-kind” exchanges outside of real estate. The removal of the loophole coupled with the IRS’ increased desire to find and prosecute those with unreported digital assets means not everyone in the cryptocurrency world will be celebrating a happy New Year when the clock strikes midnight on December 31st, and every single cryptocurrency exchange becomes instantaneously taxable.
Up until now, many Bitcoin and cryptocurrency investors have avoided paying taxes on cryptocurrency exchanges through an interpretation of an exemption in the tax code called the “like-kind” exemption. The exemption allows for the exchange of “property” without creating a taxable event. Historically, the loophole has been used by traders to exchange items such as real estate and art without having to pay taxes on the transaction. At the time of the exemption’s drafting, cryptocurrency had not come to fruition, and thus cryptocurrency was not listed with items such as stocks and bonds that were not allowable under the exemption. However, in 2014 the IRS did release guidance stating that Bitcoin and cryptocurrencies were considered “property” and not “currency.”
Numerous cryptocurrency investors and their lawyers have interpreted the exemption to allow for the exchange of one cryptocurrency for another without an immediate tax obligation because the IRS considers cryptocurrency as “property.” Under this interpretation, an investor could exchange Bitcoin for Litecoin without the duty of paying taxes on the transaction. Most cryptocurrencies do not allow for direct purchasing via U.S. dollars. They require another type of cryptocurrency which makes this provision extremely relevant to the cryptocurrency investing world. The IRS was asked for guidance on how Bitcoin and cryptocurrency relate to the “like-kind” exemption by many groups including the American Institute of Certified Public Accountants (AICPA) but has yet to answer publicly.
Although cryptocurrency investors may not have been subject to taxes when exchanging one cryptocurrency for another, they were subject to income and capital gains taxes according to the IRS. Coins held less than a year are taxed as regular income and taxed at a rate based on the investor’s income which could vary from 10-37%. Conversely, coins held longer than a year are taxed as capital gains and are subject to rates as high as 25%.
Even though the IRS has been quite clear regarding the taxation rules surrounding Bitcoin and cryptocurrencies, many cryptocurrency investors failed to report their gains and losses on their tax return in previous years. Specifically, only 802 of an estimated 480,000 investors who utilized a website called Coinbase for cryptocurrency investing reported their gains or losses to the IRS between 2013-2015. The lack of reporting caused the IRS to seek a court order to force Coinbase to relinquish the records of investors from 2013-2015. Coinbase fought the request but ultimately had to give the IRS records of over 14,000 investors who purchased or sold cryptocurrency on their platform from 2013-2015.
In anticipation of cryptocurrency investors continuing to fail to report their gains and losses, the IRS has been employing various means to pragmatically identify Bitcoin investors including licensing a software called Chainanalysis since 2015. In the contract between the IRS and Chainanalysis obtained through a Freedom of Information Act request by the Daily Beast, it states that the purpose of the partnership is to help “trace the movement of money through the Bitcoin economy” and find those who “may be trying to conceal income.”
Contrary to popular belief, Bitcoin is not truly anonymous like many other cryptocurrencies; it’s pseudonymous which allows Chainanalysis to identity investors. Just like an author’s penname or a personal cell phone number, a Bitcoin address is only as anonymous as one allows it to be. Once a party receives an address with a personal identifier, the address can be linked to an investor and the address may be searched and tracked on the Bitcoin blockchain. The Chainanalysis software deploys millions of tags to help trace and identify Bitcoin transactions between wallets and on exchanges. Chainanalysis’ website boasts that they have checked over $15 Billion worth of Bitcoin transactions on behalf of their customers and according to the co-founder, the company has information on 25% of all Bitcoin addresses.
Although being taxed at the time of exchanging one cryptocurrency for another may seem trivial to the outsider looking in, it has substantial financial implications for those who have a diversified portfolio which is a majority of the cryptocurrency investing community. With the skyrocketing increases in the value of many cryptocurrencies including Bitcoin, the change will be hard to ignore. Now investors not only face high transaction fees, income taxes, and capital gains taxes but taxes when they exchange one cryptocurrency for another. Given the current cryptocurrency landscape in which most cryptocurrencies cannot be purchased directly with U.S. dollars and require a two-step exchange, the altering of the “like-kind” exchange provision will dramatically affect the bottom line for many cryptocurrency investors. With the IRS spending more and more resources on legal battles and technology to identify Bitcoin and cryptocurrency users, the effect will be the crypto world responding with what they do best: cryptography. The Tax Reform Act of 2017 may inadvertently make 2018 the year of the truly anonymous cryptocurrency.