Cryptocurrency is cool these days. And since this Tax Blog aspires to be cool (with mixed results), allow me to examine the latest offering from the IRS regarding cryptocurrency. Under the heading of “better late than never,” in General Counsel Memorandum 202124008, published June 8, 2021 (the “Memo”) the IRS published guidance stating that pre-2018 exchanges among Bitcoin, Ether, and Litecoin are not eligible for tax-free treatment under tax code Section 1031.
In the Memo, the IRS defines Bitcoin, Ether, and Litecoin as “forms of cryptocurrency, a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.” Seven years ago, in Notice 2014-21, the IRS concluded that cryptocurrencies were property, and not actual currency, and that general tax principles applicable to property transactions apply to transactions involving cryptocurrency.
Section 1031(a)(1) of the tax code applies to property transactions, and provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. As of January 1, 2018, Section 1031 has been limited to exchanges of real property. But prior to that, Section 1031 could also be applied to exchanges of personal property, such as cryptocurrency.
Applicable regulations define “like kind” to mean the nature or character of the property, and not the grade or quality. For example, an investor who exchanged gold bullion for silver bullion pre-2018 could not use Section 1031 because silver is primarily used as an industrial commodity, while gold is primarily used as an investment. Similarly, an investor who exchanged one kind of gold coin for another kind of gold coin could not use Section 1031 because one coin’s value was based on collectability while the other’s value was based on metal content.
With regard to cryptocurrency, the IRS concluded that both Bitcoin and Ether had a special role in cryptocurrency trading since investors wanting to trade in other cryptocurrencies had to exchange the other currencies into, or from, either Bitcoin or Ether. Bitcoin and Ether acted as an on- and off-ramp for investments and transactions in other cryptocurrencies. This special role differentiated both Bitcoin and Ether from Litecoin (and likely most other cryptocurrencies). Therefore, exchanges between Litecoin and either Bitcoin or Ether were not like-kind exchanges under Section 1031.
The IRS further concluded that Section 1031 was not available for exchanges between Bitcoin and Ether because of differences in design and usage. Bitcoin is designed to act as a payment network, with Bitcoin acting as the unit of payment. But the Ethereum blockchain was intended to act as a payment network and to act as a platform for operating smart contracts and other applications, with Ether working as the “fuel” for these features. As a result, the IRS concluded that Bitcoin and Ether are not like-kind property.
It is not clear why the IRS took so long to publish guidance on the application of Section 1031 to cryptocurrency exchanges. Investors may now be exposed to back taxes, interest, and penalties for not reporting their gains on pre-2018 exchanges. The general statute of limitations is three years from the date the tax return was filed, so the statute of limitations would have expired for 2017 and prior tax years, assuming a 2017 return was filed by April 15, 2018. However, cases where the taxpayer failed to report more than 25% of their income are subject to a special six-year statute of limitations. Accordingly, the statute of limitations for investors who recognized substantial gains from trading cryptocurrencies might be open for years going as far back as 2015 tax year. So although the guidance will not affect most taxpayers, it may be significant to others.