By Eric P. Rothenberg, Esq. (Published Article)
The world of cryptocurrency transactions was changed dramatically at the end of 2017 when the Internal Revenue Code [“IRC”] was modified to remove all types of assets eligible for Tax Free Exchanges under IRC Section 1031 [also known as “1031 Transactions] EXCEPT for real estate. Prior to 2018, you could exchange farm animals, rail cars and office equipment, etc. After 2017, only real estate will qualify. In my previous articles on cryptocurrency tax aspects, I discussed that the IRS has treated, since 2014, all cryptocurrency as “property” and not as either currency or security. The SEC, however, does treat it as a security, and FinCEN, the short name of the Financial Crimes Enforcement Network, a department within the US Treasury, treats it as currency. With three differing views of the same intangible object, confusion abounds.
Prior to 2018, you could trade cryptocurrency coins for other virtual coins and not be taxed, as the exchange qualified as a tax-free exchange under IRC Section 1031. But since 2017, that is no longer the case and every exchange is thus taxable. But there is very little guidance on the accounting for these transactions. In 2014, the IRS issued Notice 2014-21. It said very little about accounting for these transactions and said: “The Treasury Department and the IRS recognize that there may be other questions regarding the tax consequences of virtual currency not addressed in this notice that warrant consideration.” Most people know that you are allowed to account selling securities and inventory under various methods. There’s FIFO [First In, First Out], LIFO [Last In, First Out], Specific Identification method, and others. With LIFO, we look to the basis of the oldest items held and use the basis for that to calculate capital gains. With LIFO, we look to the basis of the last items acquired to calculate basis which some folks like to use because when prices are going up, that will produce a lowest gain with a due to a higher cost basis. With specific identification, you choose what to specific item to sell to either yield the higher gain or lower gain [or higher loss or lower loss, etc.] depending upon your tax need at the time. There is also the moving average in which you compute the average cost per unit of all like assets. This has been the case for a long time for mutual funds with dividend reinvestment over many years. Thus, if you have bought Bitcoins over a year or more, you would compute the average cost of all coins [i.e. total cost to buy divided by the total number of coins you received to compute the average cost per coin]. And finally, there can by hybrids of these methods.
STILL UNKNOWN WHAT METHODS WILL BE ALLOWED
The problem here is that there is no direct authority for any of these methods, due to inaction by the IRS. Notice 2014-21 came out in August, 2014 and since then, the IRS has been virtually silent [that’s a double entendre! “virtually”]. That has even rattled Congress and in September, 2018 five members of Congress wrote to the Commissioner of Revenue of the IRS asking them to take action and issue guidance of these matters. Also, the American Institute of Certified Public Accountants (AICPA) sent two letters to the IRS requesting guidance since 2014. That means tax returns were filed in 2017 and will soon be filed for 2018 with us all guessing on how this will all turn out. As a tax lawyer who prepares income tax returns, I have to grapple with these issues as well and advise my clients on what to do. But the issues have gotten far worse since crypto began in 2011.
LARGE VOLUMES OF TRADES
With the use of online exchanges [as opposed to pieces of paper with the owner’s private key on it which was how cryptocurrency was originally traded], people can do hundreds, if not thousands, of transactions each year. When I first began preparing returns in 1976, stocks and bond transactions were accounted for by giving the preparer the confirmation slips of the buys and sells and matching them up. With the advent of small business computers, the brokerage houses quickly utilized computers and this became the way trades were accomplished. Taxpayers received printouts of the sales proceeds and the cost basis. In the 1990’s, when the PC became the norm, individuals could then do their own stock trading and the advent of “day trading” began. It was also about this same time that software was developed to trade stocks on their own, with no human intervention, based upon the portfolio manager’s guidelines. That same software was able to cause stock market crashes [first in 1987, then in 2010 and several other “flash” crashes which lasted for seconds rather than days]. Today only about 10% of all stock trades are made by humans. And robot-trading has also invaded the cryptocurrency world. That means thousands of trades done by software and not humans. It also means a nightmare of accounting for them since 2017 when they were no longer eligible for tax free exchanges. Those who waded into the crypto waters, never give the volume of a trades a thought until usually after the first year and it’s time to report the transactions to the IRS. When they first come to see me, I give them my lecture about the ways they can report gains and losses [LIFO, FIFO etc.] but they give me a deer in headlights stare back as to how they can get me that information in a useful form. They also can go to websites that promises to pull [for a fee] the trade data from the various cryptocurrency exchanges and sort it or give it to you in a tax spreadsheet [see, for ex., www.bitcoin.tax, or https://bear.tax].
Until recently, the values of cryptocurrencies steadily rose from 2011 until 2017. But then beginning in November, 2018, there was a precipitous drop in value from the high of December 2017. Some coins are down over 80% which means some taxpayers have substantial losses. The good news, for now, is that anyone can sell the coins and recognize the losses, and immediately buy them back and not run afoul of the so-called “wash-sale” rules that apply. That means closing out all coins and restarting basis as of now and making it much easier to figure out future basis when the prior data is either overwhelming or lost entirely (some exchanges went out of business or were shut down governmentally and all records were lost). Of course, the tradeoff for a fresh accounting start is the holding period starts anew and the coins repurchased need a new one-year period to qualify for long term capital gain treatment. And coins “mined” are not a part of this article as they are ordinary income assets and not capital assets.
MOVING AVERAGE COST BASIS
The moving average concept to account for cryptocurrency transactions is gaining traction. Many of my clients don’t understand the website calculators and want to gain more control over the positions themselves. I created a “Moving Average” spreadsheet for clients that allows them just to enter the date, price per coin and number of coins for purchases and purchases [as a minus reducing the coins held] and the spreadsheet does the rest. The IRS has issued regulations not for cryptocurrency but for the general basis rules in IRC Section 1012. To use the “average basis” one elects to do so. But the IRC 1012 states it’s for stock of regulated investment companies and cryptocurrency is not a stock of any kind to the IRS even though the SEC does treat the virtual currency as a security. Thus, it’s entirely possible the moving average basis for accounting won’t apply but we don’t know either way. Most experts in this field believe that a reasonable method of accounting for cryptocurrency transactions will be okay, but there’s no guarantee. If you do use the moving average method, then note that there are two ways within that method as well. There’s the single category and the double category. In the single category, you have one system of accounting and for any sale, the holding period is determined [long term or short term] by using the date oldest first. The second method was available until 2011 and while we don’t know how this will turn out in the end, for now let’s just stay with the one method.
Accounting for transactions in cryptocurrency is as much a part of the wild west as is trading in the coins themselves. There’s very little guidance to go on and it’s only recently that the government realizes that they are here to stay and requires a lot more guidance. Of course, guidance can have a direct effect on the value of these currencies as well since the tax aspects often affect the value of property. This is a worldwide phenomenon and not local to the US. On December 19, 2018, the UK issued tax guidance for the currencies for individuals, but not businesses. For now, it is very difficult accounting for these trades and is unlikely to be resolved at all until regulations are issued and the cases are litigated as is inevitable.