Like-Kind Exchange Treatment For Crypto Currencies

Update: With the passage of the Tax Cut and Jobs Act in late 2017, IRC Section 1031 is no longer applicable to assets other than real property. For tax years 2018 and later, virtual currency users may not defer gain using the code section referenced in this post.

One question that I frequently receive from clients is whether trading between different cryptocurrencies is a taxable / reportable event. As is often the case with US tax law, the answer is “maybe.”

With its classification of bitcoin as a form of property (not currency) earlier this year, the IRS removed much of the uncertainty surrounding tax treatment for cryptocurrencies.  While the tax rate that applies to cryptocurrency gains is likely to be lower in most cases, property treatment imposes substantial record keeping requirements on taxpayers who regularly trade or use them.

Cryptocurrencies (the IRS uses the term “virtual currencies”) can be treated either as capital assets or non-capital assets, depending on whose hands they are in at tax time.  “Property” is not a meaningful term insofar as the Internal Revenue Code is concerned, since everything owned by a taxpayer would be considered property.  Inexplicably, this is the term the IRS chose to differentiate between foreign currency treatment and capital / non-capital asset treatment.

For crypto enthusiasts who invest and trade for their own account, bitcoin is likely to be treated as a capital asset. This means that each acquisition and disposal normally must be recorded and reported as a separate event for tax purposes. I use the terms “acquisition” and “disposal” here to highlight the fact that receiving virtual currency in exchange for goods or services and “spending” it must also be tracked- not just deliberate trading activity.

Capital asset treatment also means that like-kind exchange rules may be available as a means to defer gain on some transactions.  A like-kind exchange, also known as a “Section 1031 exchange” (for the section of the Internal Revenue Code where it can be found), allows deferral of gain recognition on an otherwise reportable and taxable disposition when the proceeds are put into another asset of like-kind. For example, if you sell a piece of grazing land held for investment and invest the proceeds in a different piece of grazing land, your gain would be deferred until you sell the second property.  More to the point, if you trade bitcoins for litecoins and realize a gain in the process, Section 1031 might allow you to postpone recognition of your gain until you convert back into fiat currency or into an asset that is not like-kind.

Like-kind exchange treatment is only available for capital assets held for investment or business purposes. The IRS explicitly excludes assets treated as inventory or stock in trade from Section 1031 (i.e. a “bitcoin dealer” or professional trader would be unable to use it).  Also, you should be aware that there are certain rules governing what kinds of assets would be considered like-kind. For example, receipt of cash or physical assets (such as gold, silver or Casascius bitcoins) in connection with the transaction would cause a portion of the gain deferral to be disallowed (the non like-kind portion is known as “boot”).  Finally, and most importantly, though I have no reason to believe that Section 1031 wouldn’t apply to cryptocurrencies treated as capital assets, I cannot confirm that the IRS would agree with me.

Certain asset types definitely don’t qualify under the like-kind exchange rules.  As of the time of this writing, virtual currencies are not one of the excluded assets.  However, cryptocurrencies are still new enough that the body of material that would be used to predict how the IRS might react to a given tax position is still very thin.  If you think that some of your gains may qualify for deferral under like-kind exchange rules, you should consult your tax adviser.