Guidance on Like-Kind Cryptocurrency Exchanges
September 1, 2021 | Cryptocurrency, IRS, IRS Memo, Like-Kind Exchanges
In IRS memo ILM 202124008, IRS Chief Counsel provided guidance on cryptocurrency exchanges and what constitutes a like-kind exchange for transactions before 2018. Throughout the memo, the IRS answers the questions: Does an exchange of Bitcoin (“BTC”) for Ethereum (“ETH”), Bitcoin for Litecoin (“LTC”), or Ethereum for Litecoin qualify as a like-kind exchange under section 1031 of the Internal Revenue Code (“IRC”)?
What is a like-kind exchange?
According to section 1031, a like-kind exchange is a swap of one business or investment asset for another. “Like-kind” applies to the nature or character of the property and not the grade or quality. The Tax Cuts and Jobs Act of 2017 further narrowed the definition of eligible property to be real property (i.e. not digital property). Eligible like-kind swaps do not require the taxpayer to recognize the gain or loss in the value of the property. Ineligible swaps require recognition of the gain or loss in the tax year the transaction took place.
In other words, if a rental company buys a house for $100,000 and in 10 years it appreciates to $150,000, it could exchange the title for another property and not recognize the $50,000 gain under section 1031. The gain would be realized (and taxed) when the new property was sold.
Bitcoin, Ethereum, and Litecoin
Cryptocurrency exchanges are digital platforms that allow users to trade one cryptocurrency for another or for fiat currencies such as the US dollar. There are some types of cryptocurrency that can only be traded with particular tokens but BTC and ETH have long been tradable with most other cryptocurrencies. As a result, cryptocurrency traders have bought BTC and ETH before they trade in other coins. Additionally, up until a few years ago, if an individual wanted to liquidate a cryptocurrency, they would have to exchange (swap) for BTC or ETH before converting back to fiat. Thus, the IRS stated in the memo that BTC and ETH have differing mission statements and proposed end-uses. Meanwhile, LTC had more limited crypto to fiat exchange capabilities compared to the other two coins. For these reasons, the IRS reasoned that each cryptocurrency plays a fundamentally different role from other currencies and have since their inception. Thus, even before the 2018 tax year when the TCJA rule change took effect, these coin swaps were not 1031 like-kind exchanges.
The Fallout
Given the rapid appreciation of various cryptocurrencies, the IRS may have a six-year window to go after the unpaid taxes for use of the like-kind rule. Any taxpayer who relied on 1031 exchanges prior to 2018 may not be safe from audit if the US dollar equivalent of the like-kind amounts reported were 25% or more of their potential income. If the IRS determines a taxpayer attempted to defraud the government, there is no limitation on the amount of time it has to pursue the tax and assess penalties.
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