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Do Cryptocurrency Trades Qualify As ‘Like-Kind Exchanges’?

By February 19, 2018Investors

Overview of Section 1031

Section 1031 generally permits taxpayers to defer gain or loss on the exchange of properties that are of a “like kind.” The basic reason for allowing nonrecognition of gain or loss in such exchanges is that the taxpayer’s economic situation after the exchange is fundamentally the same as it was before the exchange occurred. Koch v. Commissioner, 71 T.C. 54 (T.C. 1978).

In order to qualify as a like-kind exchange under Section 1031, a transaction must satisfy three conditions:

  1. There must be a mutual exchange of property between two or more taxpayers;
  2. Both the property that the taxpayer gives up and the property that the taxpayer receives must be held for business or investment use; and
  3. The property given up must be of a “like kind” to the property that is received

Requirement #1: Exchange of property

From the outset, a like-kind exchange must in fact constitute an “exchange,” i.e. not a sale. This generally requires a reciprocal transfer of property between two parties.  The exchange of the property must occur simultaneously and in a mutually dependent manner. The involvement of a third party to accommodate the exchange is generally permissible, so long as no cash or other non-like kind property is involved in the transaction. If cash or non-like kind property is involved (known as “boot”), the third party must be a “qualified intermediary” within the meaning of Treas. Reg. 1.1031(k). Otherwise, the receipt of boot in the transaction will trigger recognition of gain.

As applied to most cryptocurrency trades, the “exchange” requirement does not appear to be an issue. Crypto-to-crypto trades generally occur on third party exchange platforms that execute the trades between the two parties simultaneously. Also, such trades are typically a straight crypto-to-crypto exchange and do not involve cash or other property. Thus, even though a third party is used to facilitate the transaction, it’s not necessary for such exchange platform to be a qualified intermediary. Therefore, this requirement would appear to be satisfied in most crypto-to-crypto trades.

Requirement #2: Use of Property

In addition to the exchange requirement, both the property transferred and the property received in the transaction must be held for the productive use in a trade or business or for the investment purposes. The determination of whether property is held for “productive use in a trade or business or for investment” is based upon the taxpayer’s intention at the time of the exchange. If the taxpayer does not intend to immediately liquidate the property or use it for personal pursuits, the property is generally considered to be held for productive use in a trade or business or for investment. This is true even if the property is in fact exchanged again immediately after it is acquired.

In the case of most crypto-to-crypto trades, this requirement is probably also satisfied. However, the determination will ultimately vary between different taxpayers and must be made on a case-by-case basis. Taxpayers who exchange crypto held for personal use or primarily for sale may be at risk of not meeting this requirement.

Requirement #3: Like-Kind Property

Under the third and final requirement, the property given up in the transaction must be of a “like-kind” to the property received. Section 1031 does not define the term “like kind,” other than to specifically exclude certain types of property from like-kind treatment (such as stocks, bonds, securities, partnership interests, and choses in action). The regulations to Section 1031 provide some clarity, stating “as used in section 1031(a), the words ‘like kind’ have reference to the nature or character of the property and not to its grade or quality.”

Thus, the properties involved in the exchange do not have to be identical, as long as they are of the same “nature or character.” As explained by the Tax Court in Koch v. Commissioner, “the comparison should be directed to ascertaining whether the taxpayer, in making the exchange, has used his property to acquire a new kind of asset or has merely exchanged it for an asset of like nature or character.” Indeed, the IRS has acknowledged that that “even the narrowest interpretation of the like kind standard does not require that one property be identical to another or that they be completely interchangeable.” T.A.M. 2000-03-5005 (Sept. 1, 2000).

In the case of intangible personal property, the “nature and character” test includes both the nature and character of the intangible property itself, as well as the nature and character of the underlying tangible property to which it relates (if any). For example, a copyright on a novel and a copyright on a song are not like-kind property, even though both are copyrights, because the underlying tangible property to which they relate is different.

When analyzing the “nature and character” of property involved in a like-kind exchange, the courts tend to focus on the economic position of the taxpayer. As explained in by the Tax Court, “it is implicit in the scheme of Section 1031 that the taxpayer’s economic situation has to fundamentally change in order for gain or loss to be recognized.” See Federal Life Insurance v. Commissioner, 76 T.C. 107 (1981). Thus, the Service has approved the like-kind exchange of bullion coins for other bullion coins, regardless of the coins’ country of origin, size, shape, or metal content. See Rev. Rul. 76-214Rev. Rul. 82-96, and Rev. Rul. 79-143.  This is because a taxpayer holding such coins remains invested in the price of gold before and after the transaction, so the taxpayer’s economic position has not changed. Rev. Rul. 82-96.

Conversely, the same logic applies to the exchange of non-bullion coins, which are valued based on their collectability instead of their metal content. The exchange of these coins (referred to as “numismatic coins”) qualifies for nonrecognition under Section 1031 despite the fact that the characteristics of the coin, such as metal type, age, strike, number minted, origin, and condition, vary greatly. Regardless of the different characteristics of each coin, the taxpayer’s investment remains in the collectible coin market and therefore the nature and character of the investment is unchanged by the exchange.

The exchange of cryptocurrencies bears some similarity to the exchange of numismatic type coins. That is because cryptocurrencies, unlike bullion coins, do not have any intrinsic value. Instead, cryptocurrencies derive their value solely from demand in the cryptocurrency market. Demand for certain cryptocurrencies, and therefore price, depend on the unique features that make each cryptocurrency more or less desirable than other available cryptocurrencies. These unique features include such things as faster processing times, better privacy protections, or the availability of smart contracts, which can be viewed as analogous to the different strike, size, condition, and metal content of numismatic type coins.

Regardless of the unique features of each cryptocurrency, the nature and character of the investment appears to remain the same. Both before and after the exchange, the taxpayer owned an asset with no intrinsic value, and which was traded only by other cryptocurrency users. The taxpayer’s economic situation, therefore, has arguably not changed in such a fundamental manner that gain or loss should be recognized.

Risk of Audit & Penalties

The above analysis establishes that at least some legal authority exists for treating cryptocurrency as like-kind property within the meaning of Section 1031. Additional authorities exist, but analyzing them is beyond the scope of this post. In any case, such legal authority is far from absolute.

In the absence of direct authority authorizing the treatment of cryptocurrency as like-kind, the IRS is free to take a contrary position. Taxpayers who treat crypto-to-crypto trades as like-kind exchanges may likely receive notice years later that the IRS has rejected such treatment and is recharacterizing their “like-kind exchanges” as taxable events. The IRS would then assess additional tax, as well as an accuracy related penalty on grounds that the use of 1031 was negligent or resulted in a “substantial understatement of tax.” Under Section 6664 of the Code, the penalty would be 20% of the additional tax owed by the taxpayer.

Fortunately, taxpayers can avoid the accuracy related penalty under three circumstances. The first is if the taxpayer had “substantial authority” for treating cryptocurrency as like-kind property. The question of whether substantial authority exists requires an objective analysis of the law and its application to the relevant facts. Ultimately, the authorities supporting the like-kind treatment must be substantial in relation to authorities supporting a contrary position. There may be substantial authority for the tax treatment of an item despite the absence of direct authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision. See Treas. Reg.§ 1.6662-4(d).

Second, taxpayers can avoid accuracy related penalties by disclosing the like-kind treatment using Form 8275, but only if there is a “reasonable basis” for the position. The regulations do not define “reasonable basis,” other than to say it is a higher standard than “merely arguable” but lower than “substantial authority.” See  Treas. Reg. § 1.6662-3(b)(3). Thus, this standard still requires a thorough and objective analysis of the law to determine whether adequate support exists for treating cryptocurrencies as like-kind.

Third, a taxpayer can avoid the accuracy related penalty if there was “reasonable cause” for treating the crypto-to-crypto trades as like-kind exchanges and the taxpayer acted in good faith taking such a position on his or her tax return. Whether a taxpayer has acted in good faith is decided on a case-by-case basis, taking all facts and circumstances into account. “Good faith” has no precise definition, but the Tax Court has previously stated that it means “an honest belief and the intent to perform all lawful obligations.” Good-faith reliance on the advice of a competent tax professional may meet the good faith requirement. In general, the most important factor in determining whether a taxpayer has acted with reasonable cause and good faith is ‘‘the extent of the taxpayer’s effort to assess his proper tax liability.’’ See Treas. Reg. § 1.6664-4.

Of the three circumstances discussed above, disclosing the tax position on Form 8275 is the most effective way to avoid penalties — assuming the taxpayer can establish that a “reasonable basis” exists for treating cryptocurrency as like kind property. Although filing a disclosure on Form 8275 might seem like it would trigger an automatic audit, such disclosures are surprisingly common and most tax returns attaching Form 8275 are not audited. In any case, the risk of audit is already considerably higher as a result of treating the crypto trades as like kind exchanges, so the added risk of Form 8275 might be only marginal.

Taxpayers who do not want to file the disclosure on Form 8275will need to have “substantial authority” for treating cryptocurrency as like-kind property. This will require a thorough and in-depth analysis of the relevant statues, case law, and regulations for Section 1031. Whether or not the taxpayer will qualify for protection from accuracy related penalties will ultimately depend on the adequacy and thoroughness of such analysis, which should be performed by a tax attorney or other competent tax professional.

Lastly, taxpayer can fall back on the “reasonable cause and good faith exception” if the other options fail. However, the reasonable cause and good faith exception is narrowly interpreted in most cases. The taxpayer will have to show that he or she relied upon the advice of a qualified tax professional, and that such reliance was reasonable and justified under the circumstances. This is generally reviewed as a last resort for avoiding the accuracy related penalties.

In either case, taxpayers electing to treat cryptocurrency as “like-kind property” under Section 1031 should seek out the professional advice before filing. Both “reasonable basis” and “substantial authority” require an in depth analysis of the law, which is best performed by a tax attorney. Obtaining an opinion letter from such an attorney will be useful for documenting the analysis and establishing that adequate authority existed for the position. Reliance on an opinion letter can also help establish “reasonable cause and good faith” in the event that the taxpayer’s legal authority is not accepted.

Bottom Line

The bottom line is that crypto-to-crypto trades can technically qualify as like-kind exchanges, but such qualification is uncertain at best. There appears to be sufficient legal authority file such trades as like-kind exchanges, but such authority is no guarantee that the IRS will accept this treatment. In the event that the IRS takes a contrary position, taxpayers will need to be able to establish that they had “substantial authority” for treating crypto-to-crypto trades as like-kind exchanges. Alternatively, taxpayers can disclose such treatment on Form 8275 and then only need to establish a “reasonable basis,” which is a lower standard. At the end of the day, taxpayers should strongly consider seeking competent tax advice on this issue rather than attempting to resolve such an uncertain issue alone.

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