Cryptocurrency Tax Questions for the New Year

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2017 was an interesting year for Bitcoin and other cryptocurrencies. As prices increased, regulators became increasingly interested in regulating certain aspects of the ecosystem. After many years of silence, we finally got some guidance from the Internal Revenue Service (IRS), which sought customer records from Coinbase after only 800-900 taxpayers reported bitcoin gains each year from 2013 to 2015. Ultimately, Coinbase was ordered to turn over information including, (1) tax ID numbers, (2) names, (3) date of births, (4) addresses, and (5) account records for customers with at least $20,000 worth of value in any one transaction (buy, sell, send, or receive).

Additionally, the recent tax bill redefined the definition of property eligible for a Section 1031 “like kind exchange”, thereby eliminating the possibility of using the section when trading one cryptocurrency for another. Although there was much debate as to whether such trades were ever eligible for like kind exchanges, most tax attorneys and CPAs I have spoken with do not believe such transactions were ever eligible, it appears that the answer is settled for 2018. Please see here and here for articles discussing the Section 1031 question.

Still, there are many significant aspects of the U.S. federal income tax treatment of cryptocurrencies that remain unclear. As we head into the new year, some of the biggest outstanding tax questions include:

What is the cost basis for tokens purchased at a Dutch Auction when the price of the cryptocurrencies used to purchase the tokens fluctuates before the price of the tokens is established?

The Raiden ICO, which took place from October 18, 2017 to November 1, 2017, is a good illustration of this. The team behind Raiden conducted a Dutch Auction, which is where the offer price starts high, and descends over time in accordance with a prespecified price function. During the ICO, purchasers could have committed the same amount of ether at different times and received the same amount of Raiden Network Tokens (RDN) after the auction. However, because the price of ether fluctuates, the cost in U.S. dollars that purchasers paid when they committed the ether to the auction could differ widely over the course of the auction. In fact, the price of ether ranged from $277.57 to $317.25 during the auction. Accordingly, a question exists as to whether the cost basis should be the U.S. dollar value at the time the ether was committed, or after the auction, which is when the price of RDN was established.

What is the cost basis and tax liability for forks?

On August 1, Bitcoin Cash was forked from the Bitcoin protocol. Everyone who owned bitcoin at the time of the fork owned the same amount of Bitcoin Cash after the fork. However, many exchanges did not initially support Bitcoin Cash and many who held bitcoin on exchanges had no way of accessing their Bitcoin Cash. For example, Coinbase customers did not receive their Bitcoin Cash until December. An initial question is whether the bitcoin holders had any tax liability at the time of the fork in August, and if so, what was the cost basis. Publications by industry experts seem to support the idea that it was a taxable event, but the cost basis and potential tax liability remain less certain. On the one hand, the Wall Street Journal has reported that the initial market price of Bitcoin Cash was $266, and on the other hand, no actual Bitcoin Cash tokens were able to be traded until after the fork, so the cost basis could be zero. The implication here is that a taxpayer may not have any tax liability until the Bitcoin Cash is sold if the cost basis is $0, since they received “property” valued at $0. To muddy the waters further, the question exists whether this should be the approach taken for all forks. Since most cryptocurrencies are open source projects, anyone can fork a cryptocurrency. Each bitcoin fork could potentially expose holders of bitcoin to tax liability for every fork, including Bitcoin Gold and the new Segwit 2X, regardless of whether the project is likely to succeed, whether the holder even wants the new cryptocurrency tokens, or whether the holder can even access the tokens in the first place.

Are cryptocurrency “wash sales” allowed?

A “wash sale” is where a taxpayer sells off an investment, realizes a tax loss, and then immediately buys back the investment. Wash sales generally apply to stocks and securities, so for some cryptocurrencies, such as bitcoin, which are unlikely to qualify as securities, there is not likely a prohibition on wash sales. If wash sales were to apply, a taxpayer would need to wait at least 30 days prior to buying back the investment to realize a loss on the initial sale. However, the SEC has recently been pursuing enforcement actions against cryptocurrency projects and the agency has been vocal that many recent ICOs have qualities that resemble security offerings. If a taxpayer sold a cryptocurrency that is deemed to be a security and the taxpayer sold such token at a loss and bought it back within 30 days, it is possible that such taxpayer could not claim the loss. Whether a specific cryptocurrency qualifies as a security is a fact-intensive analysis that is performed on a case-by-case basis.

How is tax liability calculated for cryptocurrency to cryptocurrency trades on exchanges that do not provide U.S. dollar values?

Many exchanges only report the price of cryptocurrency trades in units of cryptocurrency, rather than U.S. dollars. For example, suppose someone wanted to purchase Ripple tokens (XRP) from Poloniex, which requires bitcoin, but only had Ethereum in their Coinbase account. Assume that they sent $1,000 worth of Ethereum to Poloniex (Price 1), sold the Ethereum for Bitcoin (Price 2), and then sold the Bitcoin for XRP (Price 3). Seeing as each transaction took place at a different time, the taxpayer could have three different prices for establishing their cost basis, even if all they wanted was $1,000 worth of XRP. The taxpayer may also have tax liability on any appreciation of the price of bitcoin during the short period between purchasing it and selling it for XRP. Complicating matters further is that these transactions need to be priced in U.S. dollars for tax reporting, but on many exchanges, including Poloniex, trades are reported in amount of bitcoin. Accordingly, the taxpayer would need to be able to calculate the price of each cryptocurrency in U.S. dollars at the exact time of each trade, which is no easy task.

 

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