You might still think that the biggest bitcoin tax problem revolves around whether or you owe taxes to the IRS on your holdings. However, many people still aren’t aware of the fact that they also owe taxes on capital gains from trading crypto.
The IRS has not provided much guidance on the nuances of owning cryptocurrency, including cryptocurrency trades. As a result, many people have simply assumed that they will be able to defer the taxes on their trades by using Section 1031 exchanges. Unfortunately, this is simply untrue as of 2018. Although, Section 1031 could be useful for prior year trades.
Here are a few answers to the most popular questions about cryptocurrency taxes. This should help clear up the mystery surrounding coin-to-coin sales tax and Section 1031 exchanges.
Are Coin-to-Coin Sales Taxable?
Yes, absolutely. The IRS has already issued guidance which states that every cryptocurrency transaction that results in a taxable capital gain or loss must be reported. For tax purposes, cryptocurrency is treated as property. Given that the bulletin did not make any distinctions between the thousands of altcoins that are being held and traded on cryptocurrency exchanges, it must be assumed that all coin-to-coin sales can trigger taxable events.
However, whether or not traders are reporting these transactions has become an issue for traders. Tracking cryptocurrency trades is extremely difficult or nearly impossible on many cryptocurrency exchanges. This is also compounded by the fact that all cryptocurrency markets are extremely volatile. Prices can change dramatically in just a matter of a few minutes.
Many full-time traders are already having to resort to special software tools to help them keep track of their trades. The limited data on trades is why so many are unsure about whether crypto-to-crypto trades need to be reported.
What Are the Rules for a Section 1031 Exchange?
You may have heard of a Section 1031 exchange. It is a tax code provision that allows like-kind exchanges of one investment asset for another. If your swap is qualified, it would allow your asset to continue to grow tax-deferred. There were no limits to how many times you could do a Section 1031 exchange prior to the passage of the Trump tax bill.
However, most tax experts seem to agree that Section 1031 only applies to exchanges of real estate. Whether or not a Section 1031 exchange can be applied to cryptocurrency is hotly debated. That is because prior to 2018, the IRS has accepted exchanges of personal property. However, with regard to corporate stock or partnership interests, these assets never qualified.
In addition, the fact that the majority of cryptocurrency exchanges are delayed or “Starker” exchanges creates a another problem. A delayed exchange is one in which a middleman holds your cash after you sell off the property you owned. The middleman then uses it to buy the property you want to replace your old property.
In the case of cryptocurrency exchanges, an equivalent of this situation would be when you exchange Ethereum tokens for Bitcoin or Ethereum. You then use your newly-exchanged Bitcoin or Ethereum to buy other altcoins.
In order for an exchange to qualify as a valid 1031 exchange, there are timing rules that must be met. To simplify matters, the sale of the old property and the purchase of the new property must be done within a specific window of time. Essentially, at the same time.
Unfortunately, this doesn’t apply to the cryptocurrency traders who say they are holding altcoins for investment upon purchasing them. These “holders” likely won’t meet the timing rules of a Section 1031 exchange. It could take anywhere from a few months to years for a particular coin to achieve the returns that the investor was looking for.
The other issue is that there are many types of altcoins, all of which serve different purposes. The exchange of these coins may not be considered as “like-kind” exchanges in order to qualify for Section 1031. This because of their different use cases. It’s also possible that the IRS could argue that some cryptocurrencies are actually securities. This would exclude them, by default, from Section 1031 treatment.
Changes to 1031 Exchange After Tax Reform
Although the tax deferral benefits afforded through Section 1031 like-kind exchanges have been under the threat of repeal for many years, the passage of the Trump tax bill initiated a major change. Section 1031 exchanges for certain personal property exchanges, including machinery and equipment, and intangible property have been disallowed.
If you’re planning to claim Section 1031 in 2018, you’re out of luck. This provision can now only be applied to real property. Section 1031 can no longer be applied to any cryptocurrency trades that were started after January 1, 2018.
Claiming Section 1031 for 2017 and Prior Year Crypto Trades
In light of these changes, if you plan to use Section 1031 as a means of reducing your tax bill on your cryptocurrency trades before 2018, you should make sure to file Form 8824 in order to provide the IRS with detailed information about each trade. It is a big mistake to fail to report swaps of cryptocurrency. In fact, if you don’t report them, you won’t be able to say that you met the rules to qualify those exchanges for Section 1031 treatment.
If you trade cryptocurrency make sure to maintain accurate records of your balances for each coin that you hold, your cost basis, and the times and dates of your trades. That information will make it easier for you to provide the information required by Form 8824. Having it will support your claim that the Section 1031 exchanges were valid in the event of a tax audit.
If you need to make any amendments to prior year returns, we highly recommend that you seek out the advice of a qualified tax professional to avoid any missteps in reporting.