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Virtual Currency and Section 1031 – A Retraction and New Position

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    We previously brought you a story suggesting that it may be possible to utilize Section 1031 of the Internal Revenue Code to defer the gain on the exchange of one type of virtual currency for another. After a considerable amount of time has passed without further guidance from the government, we have decided to retract and revise the position taken in our prior posting located here.

    First and foremost, it is critical to understand that the blog postings that we provide are not legal advice and should not be considered to be or relied on as such. We aim to discuss issues that are relevant to taxpayers and tax practitioners, alike.

    What is Section 1031?

    Section 1031 of the Internal Revenue Code is a deferral mechanism that allows a taxpayer who exchanges investment property with like-kind investment property to defer any gain until such property is exchanged for property that is not of a like-kind, such as cash.  Instead of being recognized, gains realized upon the exchange of like-kind property are tracked in the asset’s basis.  When the asset is ultimately exchanged for property that is not of a like-kind, the taxpayer will recognize gain to the extent that the sale proceeds exceed the asset’s basis.

    There are numerous court cases, Private Letter Rulings, and other administrative guidance that aim to determine whether two investment properties are similar enough to be considered like-kind. In practice, the government is the true arbiter of what assets are like-kind and what assets aren’t.

    In a recent letter to the IRS, the Association of International Certified Professional Accountants asked the Service to provide guidance as to whether varying types of cryptocurrency were like-kind properties for Section 1031 purposes. In Notice 2014-21, the IRS’ guidance on virtual currency, the Service plainly states that virtual currencies are property and not currency for U.S. tax purposes. Thus, it appeared to be reasonable that a taxpayer may be able to utilize Section 1031 to defer any gains if he or she were to exchange Bitcoin for Etherum, for instance.

    But since the release of Notice 2014-21, the IRS and the federal government as a whole have shown a considerable amount of hostility toward virtual currency.  Last year, the IRS issued a hotly contested John Doe summons directed at Coinbase, a virtual currency exchange. Recently, the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) has cracked down on virtual currency exchanges that have not registered with the federal government as a Money Services Business.

    The recent regulatory enforcement constriction as it relates to virtual currency appears to evidence a shift in the government’s position and suggests the IRS is beginning to view cryptocurrency more like actual currency and less like investment property. Our change in opinion with regard to Section 1031 applicability is a result of this apparent shift. A taxpayer exchanging Euros for U.S. Dollars would not be able to rely on Section 1031 to defer any currency exchange gain and so it appears that the same could be said about exchanging one type of virtual currency for another.

    As with all investment activities that could carry significant tax consequences, it is in your best interest to consult with an experienced tax attorney to determine whether the compliance and tax costs of your investment outweigh your potential investment gains. Further, with the IRS increasing its enforcement of tax compliance laws surrounding Bitcoin and other virtual currencies, a prudent cryptocurrency investor should consult with a criminal tax defense lawyer to ensure that all prior year omitted cryptocurrency transactions are properly reported in accordance with Federal and State law.  This could involve merely amending prior year returns through the nearest service center or a formal Foreign or Domestic Voluntary Disclosure depending upon our firm’s opinion of the inherent criminal tax exposure in your individual fact pattern where multiple years of noncompliance involving cryptocurrency exits.

    The tax and accounting professionals at the Tax Law Offices of David W. Klasing have extensive experience in both advising clients on the mechanics of Section 1031 of the Internal Revenue Code as well as advising clients on the compliance requirements that result from investing in Bitcoin / Cryptocurrency. Our team of zealous advocates is available to develop a well informed and thought out strategy tailored to your case. Don’t let the threat of an eggshell audit or criminal tax investigation or targeted IRS or State Tax Enforcement Action keep you up at night. Contact the Tax Law Offices of David W. Klasing today for a reduced-rate consultation.

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