Square Pegs in Round Holes: Cryptocurrency Taxation

Justin Henning – Around February, everyone starts to panic about filing their taxes. The hottest question surrounding taxes this year is how to report cryptocurrency. However, the answer remains unclear, leaving many unsure of what to do with their Bitcoin, or other cryptocurrency, when filing their taxes this year. The IRS has attempted to answer some of these questions in a recently published notice.

In the notice the IRS states that “for federal tax purposes, virtual currency is treated as property.” This is one of the earliest attempts to classify and regulate cryptocurrency. Initially, this excited a lot of people because 26 U.S.C. 1031, the “like-kind exchange” property exemption, stated that there is no gain or loss realized when like-kind property is exchanged so long as the property is “held for productive use in a trade or business or for investment.” Put simply, if two people exchange office buildings, there was no gain or loss realized, and thus no taxes paid on the exchange.

However, reliance on this exemption in regards to cryptocurrency may lead to IRS penalties because the code was amended, and now states that no gain or loss is realized when there is a like-kind exchange of real property. Thus, cryptocurrency does not classify as no-gain no-loss like-kind property for tax purposes. Further, the code says that the exemption “shall not apply to any exchange of … stocks, bonds or notes.” While most cryptocurrencies are not considered stocks, they fit better into the stocks category than the real property category, meaning the like-kind exchange exemption would not apply. In other words, every transaction or exchange made with cryptocurrency is likely taxable.

Another issue surrounding cryptocurrency taxation is how to determine gains and losses, and when they are realized. Originally, it was thought that cryptocurrency gains were realized only once the cryptocurrency was converted back into dollars. However, having no exemption for like-kind exchanges means that there is a gain or loss realized anytime a cryptocurrency is bought, sold, or exchanged. This means that cryptocurrency traders have to report every transaction they made throughout the year. This will result in traders owing significant amounts of money to the IRS that they may not have been accounting for when trading.

It is contentious to enact a rule retroactively because it does not allow individuals to prepare for the consequences of their actions. Some people may have refrained from making certain trades or a certain volume of trades if they knew the tax consequences. Further, people who wanted to report their transactions did not know to what extent their transactions would be taxed or how to report them. It is a significant burden to require individuals to go back and report every trade without prior notice, and then tax each transaction.

Luckily, there are companies who now offer tax services specifically geared towards cryptocurrencies, such as Bitcoin.tax and Cointracking.info, where one can link their exchanges and have their trades uploaded. However, there is still speculation about IRS enforcement and how the rules will change in the future. This taxation uncertainty may be toxic to the advancement of cryptocurrency and the underlying technology because less people will purchase cryptocurrencies if there continues to be a risk of huge tax penalties at the end of the year.

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