Navigating the Complex World of Cryptocurrency Taxation
The world of cryptocurrency taxation is a complex and ever-evolving landscape. As digital assets like Bitcoin and Ethereum have gained mainstream acceptance, the Internal Revenue Service (IRS) and lawmakers have grappled with how to effectively and fairly tax these novel financial instruments. In this article, we'll dive into the nuances of cryptocurrency taxation, exploring the key principles, court cases, and strategies that shape this dynamic field.
The Rundown
1. Cryptocurrency's unique properties and uses have challenged traditional tax principles, leading to a complex and sometimes ambiguous taxation landscape for investors and users.
2. This article dives into key cryptocurrency taxation concepts, from the IRS's foundational property classification to the nuanced treatment of mining, staking, airdrops, hard forks, and lending.
3. As cryptocurrency becomes more intertwined with traditional finance, new tax questions emerge, along with opportunities for proactive tax planning, including the use of loans to defer realizing gain from the sale of crypto.
The Fundamentals: Property, Not Currency
One of the foundational concepts in cryptocurrency taxation is the IRS's classification of virtual currencies as property, not currency, for federal tax purposes. This principle, established in IRS Notice 2014-21, means that general tax principles applicable to property transactions are applied to cryptocurrency transactions. The notice also defines "virtual currency" as a digital representation of value and "convertible virtual currency" (CVC) as a type of virtual currency that has an equivalent value in real currency or acts as a substitute for real currency.
This classification has significant implications. When you sell, spend, or exchange cryptocurrency, you're engaging in a property transaction that may trigger a taxable event. The amount realized is the sum of the money received plus the fair market value of any other property received. Your basis in the cryptocurrency is the cost of acquiring it, and your holding period determines whether any gain is short-term or long-term.
Mining and Staking: Services Rendered
Another key area of debate revolves around the taxation of block rewards from mining and staking. IRS Notice 2014-21 concludes that mining cryptocurrency results in ordinary income from services equal to the fair market value of the tokens received. Similarly, block rewards, which include newly minted cryptocurrencies, are considered compensation for services and are taxable at fair market value upon receipt. The same generally applies to staking rewards.
However, this view is not without controversy. Some commentators argue that staking rewards should not be taxable until the tokens are sold. They contend that validators do not truly "create" new tokens in the same way that a baker creates a cake, but rather execute a predefined protocol. There are also concerns about "phantom income" - the taxation of new tokens without considering the dilutive effect on the value of all tokens.
These arguments often invoke parallels to traditional industries and concepts. For example, some liken block rewards to stock splits, where more shares are issued but there is no corresponding increase in value for shareholders. Others point to the seminal tax case Eisner v. Macomber, 252 U.S. 189 (1920), which defines income and is used to argue against the taxation of staking rewards at the time of creation because it does not result in the separation of a gain from capital.
Hard Forks, Airdrops, and Chain Splits
The IRS has provided guidance on the tax treatment of hard forks, soft forks, and airdrops. A hard fork occurs when a single cryptocurrency splits into two, resulting in the creation of a new cryptocurrency alongside the original. The IRS has ruled that a hard fork followed by an airdrop of the new cryptocurrency is a taxable event, whereas a hard fork without the receipt of new cryptocurrency is not.
In contrast, a soft fork, also known as a chain split, is a protocol change that does not result in a divergence of the ledger or the creation of a new cryptocurrency. According to the IRS, a soft fork does not result in any gross income for the taxpayer.
An airdrop is a distribution of a cryptocurrency to multiple taxpayers' distributed ledger addresses, often for free. The IRS considers the receipt of cryptocurrency from an airdrop following a hard fork as a taxable event. The new cryptocurrency is taxable as ordinary income at its fair market value on the date it's received.
Foreign Reporting Requirements
As cryptocurrencies transcend national borders, foreign reporting requirements come into play. Two key regimes to be aware of are the Foreign Bank Account Reporting (FBAR) and the Foreign Account Tax Compliance Act (FATCA).
Currently, the Financial Crimes Enforcement Network (FinCEN) does not consider virtual currency to be reportable on FBAR. Thus, a foreign account holding only virtual currency is not subject to FBAR reporting, unless the account holds other reportable assets. However, FinCEN has indicated that it intends to propose amendments to its regulations to include virtual currency as a type of reportable account.
FATCA, which requires reporting of foreign financial assets, may also encompass cryptocurrencies. The Treasury and the IRS have requested comments from the public on the proper treatment of digital assets under FATCA, but as of now, no guidance has been issued.
Navigating the Challenges
Beyond these foundational debates, cryptocurrency taxation presents a host of practical challenges. The volatile nature of cryptocurrencies makes determining the fair market value of rewards difficult. The decentralized nature of cryptocurrency makes tracking transactions and enforcing tax compliance a daunting task.
Moreover, the ability to create new digital assets with attributes similar to existing ones allows traders to structure transactions to receive tax-favorable treatment without meaningful changes in economics. Digital assets are not explicitly subject to wash sale and constructive sale rules, which prevent taxpayers from claiming a loss on the sale of property if they repurchase substantially identical property within a specific timeframe (Section 1091) or from deferring gains by entering into transactions that limit the economic risk associated with the property but do not transfer ownership (Section 1259).
Emerging Issues and Tax Strategies
As cryptocurrency becomes more intertwined with traditional finance, new tax questions emerge, along with opportunities for proactive tax planning. For example, rather than realize a gain by selling a cryptocurrency, one might instead loan cryptocurrency or pledge cryptocurrency as collateral for a loan. But, when is a cryptocurrency loan truly a loan for tax purposes? We can look to tax cases that determined similar issues in the context of fiat currency to engage in tax planning with cryptocurrency. Key cases that address what constitutes indebtedness for tax purposes include Gilbert v. Commissioner, 248 F.2d 399 (2d Cir. 1957) and Arlington Park Jockey Club v. Sauber, 262 F.2d 902 (7th Cir. 1959). In these cases (and others, which followed these precedents), the courts considered factors such as an unconditional promise, enforceability, subordination, and capitalization to determine if the expectation of repayment is reasonable.
In the realm of crypto lending, if a borrower can sell borrowed crypto, the lending constitutes a sale. It is controversial whether lending combined with an obligation to return fungible crypto is a realization event for the lender. Case law like United States v. Phellis, 257 U.S. 156 (1921), Weiss v. Stearn, 265 U.S. 242 (1924), and Marr v. United States, 268 U.S. 536 (1925), which deal with corporate reorganizations, have been used in the analysis of lending crypto.
Whether pledging cryptocurrency as collateral for a loan in dollars is a taxable realization event is a more nuanced question that depends on how the transaction is structured and whether it is considered a true loan or something else. If a taxpayer transfers cryptocurrency to a wallet, address, or account controlled by another person, it is generally considered a disposition and a taxable event, unless it is a bona fide gift. In the case of a traditional loan, there is an expectation of repayment, typically with an unconditional promise to pay a sum certain, and the right to enforce payment of principal and interest. If a loan is structured with these characteristics, the transfer of cryptocurrency as collateral may not, by itself, be a realization event. The lender is seen as holding the asset as security, and the borrower retains ownership.
A key factor in determining if a transaction is a loan is whether there is an obligation to pay a sum certain. If a borrower is obligated to return the same number of coins without regard to their value, it is questionable if this qualifies as a promise to pay a sum certain and may not be considered a loan for U.S. tax purposes. However, if the borrower is obligated to pay back coins worth a specific dollar amount plus an amount to compensate for the time value of money, this could meet the "sum certain" requirement. The expectation of repayment must also be reasonable, and the obligation must be enforceable. If a smart contract governs the loan, its enforceability is a factor.
Even if the initial pledge of crypto as collateral is not a realization event, using crypto to repay a loan is generally considered a sale or exchange of that property by the debtor. Thus, repaying the loan with crypto would trigger a taxable gain or loss for the borrower.
Traditional repo analysis for securities should also be applicable to cryptocurrency repos. A repo is a written agreement that provides for a sale and repurchase of an asset. If the purchaser can sell the assets not only to the original seller but also to third parties, the transaction is treated as a true sale for tax purposes.
Gifting cryptocurrency does not trigger a taxable event for the giver, though the recipient takes the giver's basis, and there may be gift tax implications. Holding onto the cryptocurrency until death could allow the recipient to receive a stepped-up basis, effectively eliminating the tax on the appreciation. A validator could hold onto rewards until death for a similar step-up in basis.
Other considerations include the fact that like-kind exchanges under Section 1031 are no longer allowed for cryptocurrency after the Tax Cuts and Jobs Act (TCJA). Charitable donations of cryptocurrency may provide a tax deduction based on the fair market value, but there are specific valuation guidelines and limits to consider.
Conclusion
The taxation of cryptocurrencies and digital assets is a complex and evolving field. As lawmakers and regulators continue to grapple with these novel financial instruments, it's crucial for taxpayers to stay informed and consult with tax professionals to navigate this landscape effectively.
From the fundamental classification of cryptocurrencies as property to the nuanced treatment of mining, staking, lending, and more, the world of cryptocurrency taxation is filled with both challenges and opportunities. By understanding the key principles, staying abreast of emerging issues, and considering strategic approaches, taxpayers can position themselves for success in this dynamic domain.
Citations
IRS Notice 2014-21 - Foundational guidance classifying virtual currencies as property
Eisner v. Macomber, 252 U.S. 189 (1920) - Used in arguments against taxation of staking rewards at creation
Gilbert v. Commissioner, 248 F.2d 399 (2d Cir. 1957) - Addresses what constitutes indebtedness for tax purposes
Arlington Park Jockey Club v. Sauber, 262 F.2d 902 (7th Cir. 1959) - Addresses what constitutes indebtedness for tax purposes
United States v. Phellis, 257 U.S. 156 (1921) - Analysis of crypto lending
Weiss v. Stearn, 265 U.S. 242 (1924) - Analysis of crypto lending
Marr v. United States, 268 U.S. 536 (1925) - Analysis of crypto lending
Internal Revenue Code Section 1091 - Wash sale rules
Internal Revenue Code Section 1259 - Constructive sale rules
Internal Revenue Code Section 1031 - Like-kind exchanges (no longer allowed for cryptocurrency after the Tax Cuts and Jobs Act)
This Toplitzky&Co publication provides information and comments on tax issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide tax advice. Readers should seek specific tax advice before taking any action with respect to the matters discussed herein.
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