Individuals who were quick to recognize the opportunity presented by cryptocurrencies like Bitcoin, DogeCoin, and Ethereum have likely rode the market to significant gains as capital from China and other developing nations have flooded the market. People who bought or mined Bitcoin due to an interest in the underlying technology or because they saw an investment opportunity may be looking to diversify their cryptocurrency holdings. In any case, they may consider changing the overall balance of digital currencies held to increase the likelihood of investment gains or hedge against potential volatility.
For individuals already holding Bitcoin or other digital currency, engaging in a like-kind exchange under Section 1031 of the U.S. Tax Code can be a viable means of exchanging one type of currency for another. Engaging in a like-kind exchange can provide tax deferral benefits for transactions that would otherwise generate capital gains taxes and be a means to much-needed diversification amongst the different types of digital currencies that tend to be very volatile. Working with a Bitcoin tax attorney can ensure that you maintain tax compliance even while minimizing the tax impact of a transaction.
A 1031 exchange can allow an individual or a business to exchange productive property for like-kind property. Most commonly, individuals will utilize a 1031 transfer to exchange like types of real property. That is, an investor may exchange one type of investment property for another type of investment property. The investor is free to pursue other investment or business goals provided that the property remains an investment property. However, an individual may not exchange investment property for a personal residence. Furthermore, there are limitations on “dealers” or other persons handling “stock in trade” leveraging a 1031 exchange.
The main benefit of engaging in a 1031 exchange is to defer liability on capital gains taxes that would otherwise be incurred at the time of sale. In deferring taxes, a property owner can reinvest the capital towards other productive uses.
Since a 1031 exchange is typically associated with the sale of property or real property, it may seem somewhat of a stretch to consider whether the concept can apply to digital currency. However, the IRS has issued guidance holding that Bitcoin and similar digital currencies will not be treated as currency for tax purposes. Rather, Bitcoin and similar cryptocurrencies should be considered property for tax purposes.
As property, Bitcoin, Ethereum, DogeCoin, and other types of crypto currency are subject to capital gains taxes and related record-keeping requirements. Since Bitcoin is treated as property and capital gains taxes apply, a 1031 exchange may produce favorable tax benefits if the variations of crypto currencies involved are held to be like kind. See conclusion below:
However, the 1031 exchange is only available when the holder of the digital currency meets certain qualifications.
For one, the holder of the digital currency must hold the capital asset for business or investment purposes. In addition, the holder of the Bitcoin or other digital currency must not be a dealer or otherwise treat the asset as inventory or stock in trade.
In the context of an individual trading Bitcoin for Ethereum, a 1031 transfer is likely appropriate if the exchange is deemed to be like-kind in nature. However, if that individual was a professional currency trader or otherwise in the business of trading currencies, then it is unlikely that he or she would be able to leverage this type of transfer absent an exception or unusual circumstances.
While it is crystal clear, the IRS excludes assets treated as inventory or stock in trade from Section 1031 treatment, as would be the case where a 1031 is attempted by a bitcoin dealer or professional trader, making 1031 effectively unavailable, no explicit guidance has been issued to clarify whether one digital currency is “like kind” with another. That being said, it remains a question whether Bitcoin is like kind with Ethereum, for example, and thus would qualify for a 1031 exchange. Additionally, the receipt of “boot” or other non-like kind property, I.E. cash, gold or silver can cause a portion of the gain potentially qualifying for 1031 deferral to be disallowed. While it would seem at present logical that Section 1031 would apply to cryptocurrencies as they are deemed capital assets, this treatment cannot be confirmed without specific Federal and State guidance on the question of whether one cryptocurrency is like kind with another.
Under the Internal Revenue Code certain types of assets do not qualify under the 1031 exchange regulations by being specifically labeled “non-like kind”. At the time of publishing, differing types of virtual currencies have not been identified as “non-like kind” or like kind with one another. Since no guidance on this subject currently exists, 1031 exchanges of differing types of cryptocurrency, while not outright prohibited, is not guaranteed to be a tax-free exchange. The conservative approach would be to not claim section 1031 on an exchange of one digital currency for another. If a taxpayer choses to be aggressive and claim the benefits of 1031 during this type of an exchange, this uncertainty should be adequately disclosed on a return taking a position that an exchange of one cryptocurrency for another should qualify for 1031 to minimize potential penalties that could apply.
If you have questions regarding whether a 1031 transfer is appropriate for your situation, the tax lawyers and financial professionals of the Tax Law Offices of David W. Klasing may be able to help. To schedule a confidential and reduced rate initial consultation at our Los Angeles or Irvine law offices, please call 800-681-1295 today or schedule online here. We can assist with Bitcoin tax planning or appeal an unfavorable Bitcoin tax determination.