By Denise Reyes, J.D., LL.M., Washington, D.C.
Editor: Greg A. Fairbanks, J.D., LL.M.
The global cryptoasset market capitalization is currently approximately $2.75 trillion,and this figure is speculated to grow as cryptoassets become more widely adopted. The IRS has released limited guidance to date on the tax consequences of cryptoasset transactions, and many issues currently remain unaddressed. Many of these matters will no doubt be clarified in the future. In the meantime, this item summarizes IRS guidance on cryptoassets, including the latest releases from the Service.
It should be noted that Congress included certain cryptoasset provisions in the Infrastructure Investment and Jobs Act, P.L. 117-58, enacted in November 2021. Under the legislation, an information return (Form 1099-B, Proceeds From Broker and Barter Exchange Transactions) must be filed with the IRS by a party facilitating the transfer of cryptocurrency on behalf of another person as a broker (Sec. 6045(c)(1)(D)). The legislation also requires a business that receives cryptocurrency worth more than $10,000 in a single transaction to report the transaction to the IRS on Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business (Sec. 6050I). These new information reporting requirements will apply to returns required to be filed, and statements required to be furnished, beginning in 2024.
The discussion below focuses on cryptoasset guidance issued to date by the IRS.
Background
According to the IRS's definition, virtual currency (the term the IRS generally uses for cryptoassets) is a digital representation of value that is not a representation of U.S. or foreign currency and that functions as a medium of exchange. Convertible virtual currency is virtual currency that has an equivalent value in real currency or acts as a substitute for real currency. Bitcoin, which was introduced in 2009, is commonly recognized as the first convertible virtual currency. IRS guidance on convertible virtual currencies was not released until 2014.
In 2014, the IRS issued Notice 2014-21, which adopts the principle that, for federal income tax purposes, virtual currency is not currency and is treated as property. The notice, in the form of 16 FAQs, outlined how to compute the basis of virtual currency and how to determine the character of the gain or loss. It also alerted taxpayers of penalties they could be subject to for failure to comply with the tax laws.
In 2019, the IRS expanded on guidance from 2014 and released Rev. Rul. 2019-24 and additional FAQs to assist taxpayers in understanding their reporting obligations. In Rev. Rul. 2019-24, the IRS ruled that a taxpayer owning a cryptocurrency that undergoes a hard fork has gross income under Sec. 61 if the hard fork results in a new cryptocurrency and the taxpayer actually, or constructively, receives the new cryptocurrency. Many of the additional FAQs focused on transactions by those who hold virtual currency as a capital asset.
Aside from issues surrounding the realization of gross income, taxpayers may have tax reporting obligations as a result of their cryptocurrency holdings. In order to increase information reporting, in tax year 2020, the IRS updated Form 1040, U.S. Individual Income Tax Return, to include a question specifically asking all taxpayers if they have received, sold, sent, exchanged, or otherwise acquired any financial interest in virtual currencies.
The remainder of this discussion focuses on two recent pieces of IRS guidance. In 2021, the IRS issued a Chief Counsel Advice memo and an IRS Legal Memorandum that discussed additional tax consequences for holders of bitcoin and certain other specific cryptocurrencies. Each of these is discussed in greater detail below.
Chief Counsel Advice 202114020
On April 9, 2021, the IRS released Chief Counsel Advice (CCA) 202114020, which discussed the tax consequences of the bitcoin hard fork that occurred on Aug. 1, 2017, where holders of bitcoin received bitcoin cash on a 1:1 ratio based on the transaction history recorded.
The CCA reiterated the tax treatment of transactions involving virtual currency as described in prior guidance (e.g., Rev. Rul. 2019-24 and the FAQs published by the IRS) and clarified the IRS's position for taxpayers who held bitcoin at the time of the hard fork. The IRS summarized the tax ramifications of two distinct situations.
In Situation 1, the taxpayer had sole control over a private key that held one unit of bitcoin. Following the hard fork, the taxpayer continued to hold one unit of bitcoin but also held one unit of bitcoin cash and had the ability to trade bitcoin cash. The IRS concluded in Situation 1 that the taxpayer had ordinary income in 2017 under Sec. 61 equal to the fair market value (FMV) of the bitcoin cash as of the date of the hard fork. As the taxpayer had the ability to trade the bitcoin cash at the time of the hard fork, the taxpayer had dominion and control.
In Situation 2, the taxpayer also held one unit of bitcoin, however, the taxpayer did not hold it directly. The taxpayer was a customer of a cryptocurrency exchange who held the unit in a hosted wallet, and the cryptocurrency exchange had sole control over the private key. Furthermore, at the time of the hard fork, the cryptocurrency exchange decided not to support bitcoin cash, which resulted in the taxpayer not being able to trade the bitcoin cash. On Jan. 1, 2018, the cryptocurrency exchange decided to support bitcoin cash, which enabled the taxpayer to trade bitcoin cash. The IRS concluded in Situation 2 that the taxpayer had ordinary income in 2018 equal to the FMV of the bitcoin cash as of Jan. 1, 2018. As the taxpayer did not have dominion and control over the bitcoin cash at the time of the hard fork, the taxpayer did not have income in 2017.
Based on the IRS's conclusions in CCA 202114020, taxpayers who held bitcoin at the time of the bitcoin hard fork may want to reassess their tax positions if they have not already done so.
IRS Legal Memorandum 202124008
On June 18, 2021, the IRS released IRS Legal Memorandum (ILM) 202124008, which addressed whether Sec. 1031 applied to certain exchanges of bitcoin, ether, and litecoin that occurred prior to the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97.
Preceding the TCJA's enactment, Sec. 1031 provided that no gain or loss was recognized on the exchange of property for property of a like kind, which could have included exchanges of some personal property and exchanges of real property. Generally, in order to qualify for like-kind exchange treatment, the property exchanged must be the same nature or character (not the same grade or quality). As previously discussed, the IRS established that virtual currency is property for U.S. federal income tax purposes and that general tax principles applicable to property transactions apply to transactions involving convertible virtual currency. However, the TCJA amended Sec. 1031 to provide that Sec. 1031 treatment is restricted to exchanges of real property.
The IRS concluded in ILM 202124008 that exchanges of: (1) bitcoin for ether; (2) bitcoin for litecoin; or (3) ether for litecoin, prior to 2018, did not qualify as a like-kind exchange under Sec. 1031. The IRS cited two old revenue rulings (Rev. Rul. 79-143 and Rev. Rul. 82-166) that each ruled that Sec. 1031 did not apply in their fact patterns to support its conclusions. For example, Rev. Rul. 82-166 concluded that an investor who exchanged gold bullion for silver bullion was required to recognize gain because gold bullion was not like-kind property with respect to silver bullion for purposes of Sec. 1031.In Rev. Rul. 79-143,the IRS held that a taxpayer who exchanged numismatic-type coins for bullion-type coins was required to recognize gain because numismatic-type coins were not like-kind property with respect to bullion-type coins for purposes of Sec. 1031.
In its analysis, the IRS compared litecoin to bitcoin and ether and determined that bitcoin and ether "played a fundamentally different role from other cryptocurrencies" during 2016 and 2017. The IRS noted that bitcoin and ether were the most regarded cryptocurrencies and served as an "on and off ramp" because taxpayers often needed to purchase bitcoin or ether before being able to purchase another coin, such as litecoin. The IRS also concluded that bitcoin and ether were not like-kind property because of their differences in overall design, intended use, and actual use.
As noted above, the ILM's conclusions related to specific exchanges of bitcoin, ether, and litecoin before the enactment of the TCJA. Taxpayers should be cognizant that the TCJA generally precludes like-kind exchange treatment for post-TCJA cryptoasset trades.
Prospective considerations
Taxpayers who have transactions in cryptoassets should anticipate and closely monitor future developments from Treasury and the IRS. Treasury has voiced concerns about cryptoassets posing a tax evasion risk, the need for stricter cryptoasset compliance with the IRS, and its intention to crack down on cryptocurrency markets and transactions.
Since 2009 when bitcoin emerged, numerous cryptoassets (e.g., platform tokens, utility tokens, and transactional tokens) have been created, adding complexity to determining the proper tax treatment.
The IRS aspires to increase tax revenues by focusing on cryptoassets, and taxpayers holding these assets must take the appropriate steps to ensure they have fulfilled all their tax-compliance obligations so that they are not penalized. The IRS has augmented enforcement efforts related to cryptoassets, including increasing efforts to serve John Doe summonses (i.e., an IRS summons, authorized by Sec. 7609(f), in which the name of the defendant is unknown to the plaintiff at the time of issuance and is added after service) on cryptocurrency exchanges in order to expose noncompliant taxpayers. The IRS is making a concerted effort to tax and regulate these transactions, and taxpayers need to be vigilant to avoid misreporting.
Besides increased information reporting under the recently enacted Infrastructure Investment and Jobs Act, additional rules may follow that affect the tax consequences of transactions involving cryptocurrencies. For example, as of this writing, proposed legislation in Congress would extend the application of both Sec. 1091 wash sales and Sec. 1259 constructive sales to digital assets. Therefore, it would be prudent for taxpayers to monitor potential legislation that could affect the tax consequences of cryptocurrency transactions.
EditorNotes
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
Contributors are members of or associated with Grant Thornton LLP.
