The IRS has issued guidance stating that swaps between Bitcoin, Ether, and Litecoin prior to 2018 will not be eligible for the 1031 tax-free exchange treatment. This means that investors who swapped between these three cryptocurrencies before 2018 are liable to income tax on the realized profits. This guide only applies to swaps prior to 2018, as the Tax Cuts and Jobs Act of 2017 removed the tax-free exchange treatment for personal property under Section 1031 from 2017 so that all cryptocurrency exchanges would be subject to income tax from 2018.
The guidance (General Counsel Memorandum 202124008) justifies that the exchange between Bitcoin and Litecoin or between Ether and Litecoin was not an exchange of similar property before 2018 – and therefore taxable – since both Bitcoin and Ether have played a special role in cryptocurrency trading since then who wanted to trade with other cryptocurrencies had to exchange the other currencies either into or from Bitcoin or Ether. This particular role that Bitcoin and Ether share sets them apart from Litecoin (and probably most other cryptocurrencies), and therefore the exchange between Litecoin and either Bitcoin or Ether was not an equivalent exchange under Section 1031.
The memorandum further concludes that the exchange between Bitcoin and Ether before 2018 was also taxable due to their differences in overall design, intended use and actual use. The memorandum states that Bitcoin should act as a payment network, with Bitcoin acting as the unit of payment. On the other hand, according to the memo, the Ethereum blockchain should act as a payment network and act as a platform for the operation of smart contracts and other applications, with ether acting as “fuel” for these functions. As a result, the memorandum concludes that Bitcoin and Ether are not property of the same kind and are not eligible for the tax-free exchange treatment under Section 1031.
The guidelines state that they only apply to exchanges between Bitcoin, Ether, and Litecoin, but it is entirely possible that the IRS could extend this rationale to other cryptocurrencies that share properties with these three cryptocurrencies. While the guidelines will only apply to cryptocurrency swaps prior to 2018, they are a strong reminder to today’s investors that any cryptocurrency exchange is now a taxable event, as tax-free personal property exchange treatment has ceased to exist since January 1, 2018.
Investors who swapped these cryptocurrencies prior to 2018 and believe these trades are tax-free could face a rude awakening to Section 1031 exchanges. It’s not clear why it has taken the IRS so long to issue guidelines on whether or not cryptocurrency swaps are tax-exempt – those guidelines come seven years after the IRS first announced that cryptocurrency should be treated as property. and not as currency for income tax purposes. Still, many investors now face after taxes, interest and penalties if they fail to report their gains on swaps before 2018. The general statute of limitations is three years from the date of filing the tax return, so the statute of limitations for the IRS review would have expired for 2017 and earlier tax years if a 2017 return was filed by April 15, 2018 (but could 2017 still be an open year if the declaration was filed upon renewal). However, a special limitation period of six years applies if the taxpayer has stated no more than 25% of his income. Accordingly, for investors who have made significant profits from trading cryptocurrencies, the statute of limitations could be open to years up to tax year 2015 (or even 2014 if they applied for an extension). Companies with a potential risk should consult an experienced tax advisor. Additionally, if the IRS claims that the failure to report cryptocurrency transactions was fraudulent, the statute of limitations for determining back taxes would run indefinitely.
Investors who swapped cryptocurrencies prior to 2018 should consult their tax advisor to determine if the six-year statute of limitations is still open, and if so, consider filing modified statements to report their gains. The IRS has received and is in the process of collecting trade information from cryptocurrency exchanges so the government may or will soon know the size of the crypto swaps that investors have made.
© 2021 Greenberg Sad, LLP. All rights reserved. National Law Review, Volume XI, Number 173