How Cryptocurrency Works With Like-Kind Property

In general, one might want to assume the rules of “like-kind property” or “like-kind 1031 exchange” do not apply to cryptocurrency. This is true even when holding cryptocurrency as an investment and despite past IRS guidance.[1][2]

In short this means, a conservative investor may want to assume the “scenario #1” listed below is the case as a safe harbor, even though it is likely that scenario #2 is the case given IRS guidance from 2014.

Scenario #1, Like-kind doesn’t apply: Treat every trade from one cryptocurrency to another as a taxable event for the year of which gains and losses can be written off against each other in that year, but not carried over to years.

Scenario #2, Like-kind does apply: Treat every trade from one cryptocurrency to another as being the equivalent of holding a single cryptocurrency. You don’t pay taxes on cryptocurrency until you convert to USD, another currency, use it as currency, or otherwise do anything other than trade or hold cryptocurrency as an investment property. You still have to account for all trades done, but you don’t owe taxes until you convert regardless of how frequently you traded one cryptocurrency for another (and regardless of profits/losses in a given year in cryptocurrency).

In both cases doing anything other than holding cryptocurrency as an investment has tax implications. So, to be clear, the discussion here is only about trading one cryptocurrency for another, when cryptocurrency is “in the hands of the investor” treated as an investment property.

NOTE: So then, what is important here is for a cryptocurrency investor to brush up on: the IRS guidance from 2014, the concept of like-kind property exchange (and how it might or might not apply to cryptocurrencies), and other related rules like the “wash-sale” rule (which applies if you sell an investment at a loss, and then buy back into the same investment or a similar one within 30 days of selling).

Disclaimer: To be clear, we aren’t offering professional tax, legal, or investment advice, and we aren’t claiming the IRS will declare that like-kind exchange doesn’t apply to cryptocurrency held for investment, we are just educating and offering friendly non-professional advice that you can organize in your own head and then take to a professional (i.e. follow the unofficial advice below at your own risk). To be clear, we suggest using the resource below as insight, and then consulting a tax professional and following IRS documentation related to cryptocurrency and sales and investment property before taking action (see the citations for official documents and more reading).

Assuming the Like-Kind Exchange Rules Don’t Apply as a Safe Harbor, Given What the IRS Has Said So Far

The above isn’t to say the rules don’t apply, in fact it is reasonable to assume they do given that the IRS has previously stated that cryptocurrency should be treated as “property” for tax purposes[3]), it is only to say that investors might want to assume the rules don’t apply as a “safe harbor until further guidance is issued (this being the investors choice, as remember, we aren’t offering professional advice here).

If one does want to assume the rules don’t apply: Treat every trade from one cryptocurrency to another as a taxable event for the year of which gains and losses can be written off against each other in that year, but not carried over to years. Also, apply the wash-sale rule to trades back and forth within 30 days. That means if you traded one cryptocurrency for another this year, you should be prepared to pay taxes on it (as a safe harbor). And it means that if you go back into the same coin within 30 days, you should apply the “wash-sale” rule when calculating taxes.

This is true despite the fact that the IRS guidance specifically says,

“For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency…

…Under currently applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes…

…The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer.

A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets.

A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.

See Publication 544 for more information about capital assets and the character of gain or loss.”

In other words, even though cryptocurrency is treated as a property, even though it is subject to the capital gains tax when held for investment, and even though the guidance says it wouldn’t generate “foreign currency gain or loss” (trading one currency for another is a taxable event for the year; i.e. it doesn’t follow the like-kind rules) it does not necessarily mean the rules of like-kind property exchange apply to cryptocurrency.

The IRS guidance sort of hints at the rules applying to cryptocurrency held strictly for investment, especially since the guidance goes out of its way to say it won’t be treated like trading foreign currency and will be treated like property held as capital asset in the hands of an investor that treats it as such… but it doesn’t explicitly say it. Hence the suggestion to “wait for guidance and assume the rules don’t apply as a safe harbor.”

Summary so far: The rules so far aren’t clear enough to just assume that you can trade one cryptocurrency for another this year and pay taxes on the gains losses next year if you are investing big money (as, in the case like-kind doesn’t apply, you could end up in a strange situation with a big tax bill). Because of the uncertainty, one should consult an accountant, keep an eye out further guidance, and generally might want to be prepared for the rules not applying as a safe harbor. That isn’t the official word or guidance, that is just a conservative take on the current official guidance. Please see the official documentation for yourself and make your own choices.

The Reason One Might Assume Like-Kind Rules Don’t Apply to Cryptocurrency

The reasoning behind the above conclusion is both practical and speculative. Reasoning includes the following points (although it isn’t limited to them):

  • The like-kind exchange rules don’t apply to investment properties like stocks, bonds, and other securities, nor do they apply to currency (trading foreign currency)… and cryptocurrency is essentially a security-currency hybrid. Yes, the IRS said it was a property, treated like a capital asset when held as such and subject to the associated rules, and yes they said it wasn’t to be treated like a foreign currency. They did not however specifically say like-kind property rules applied.
  • People could use like-kind exchange rules as a loophole to avoid paying income taxes (by shifting all their money into cryptocurrency, not taking it out, and instead using cryptocurrency rather than national fiat currencies). It is obviously in interest of the IRS and state in general to avoid this… although one could make other compelling arguments against this stance. That said, this is the exact type of regulatory murky-ness that someone who has traded large amount of cryptocurrencies should be cautious about.

With all that said, one could also provide counter-arguments to this saying things like “well, you have to take your money out sometime and you’ll pay taxes then” or “people could use the volatility of the market to show capital losses each year, and thus the rule not applying has even more implications!”

This page isn’t about debating the points, it is about becoming aware of the uncertainty and knowing where to look to do further research.

The IRS notably said that how exactly cryptocurrency is taxed depends on how you use it and that along with the other factors noted above is likely to be the saving grace that allows investors to treat cryptocurrency traded in 2017 as if the like-kind rules apply (remember, it is “assume they don’t,” despite it being reasonable they will).

So if you are using cryptocurrency as an investment, like real estate, and you aren’t using it like cash, an argument can be made that like-kind really should apply (meanwhile, to be clear, if you are using it as a currency, it might be harder to make that claim).

Still, this page isn’t about debate and logical arguments, its about safe harbors, cautions, and warnings to keep in mind when consulting a professional for investment, legal, and tax guidance.

The bottomline here is the current regulations are somewhat murky, and for the above reasons and more it is rational to assume that like-kind exchange rules won’t apply (even when holding cryptocurrency as an investment only), and thus it is conservative and sensible to use err on the side of caution until further notice. As this will help you avoid a panic at the end of the year or at tax time.

Details on Cryptocurrency and Like-King Exchange

Speaking to the above, to make things clearer, what we are saying is one should assume that trading one cryptocurrency for another is like trading one currency for another or one security for another (even though it is classified as “property” by the IRS). That means every time you trade one cryptocurrency for another, it is an independent taxable event for the year and gains and losses will be owed at the fair-market value in USD at the time of the trade (in other words, until further notice, trading a Bitcoin for a Litecoin should be treated as the equivalent of cashing out your Bitcoins and taking them as US dollars).

This means, assuming the rules don’t apply (which to be clear is an assumption):

  1. Losses and gains from trading one cryptocurrency for another within one year cannot be written off against losses and gains from another year.
  2. Simply trading one cryptocurrency for another counts as a taxable event for the year in which a profit or loss from the “sale” must be accounted for in USD at a fair-market value at the time of trade.

This has major tax implications for high frequency traders that trade one cryptocurrency for another (but has very little implication for anyone sitting on a single cryptocurrency).

“If you trade business or investment property for other business or investment property of a like kind, you do not pay tax on any gain or deduct any loss until you sell or dispose of the property you receive. To be nontaxable, a trade must meet all six of the following conditions…. 3. The property must not be stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest, including partnership interests.”

the IRS describing the like-kind rule, the one we are discussing. All the IRS has to do to make the rule not apply is treat cryptocurrencies like securities in future regulations. As of September 8, 2017 no clear guidance has been given on the issue. Thus, assuming the worst (that they don’t apply) is a “safe harbor.” [4][5]

Consider,

  1. If you buy a single cryptocurrency and sit on it, then you simply owe taxes when you trade it for another cryptocurrency or USD (so if you buy in 2013 and cash out in 2018, great, good on you, you pay taxes on the gains in 2018 only).
  2. If you buy cryptocurrency and then trade it for another cryptocurrency or USD in the same year, then you owe taxes on your gains/losses in that year. For example, in 2017, then trade it for a profit in 2017 by trading it into another coin, then that new coin loses value in 2018… you will still owe taxes on your 2017 gains.

In other words, if have been trading cryptocurrency and not just sitting on it, you’ll need to square up with the IRS this year. Assuming the rules of like-kind exchange don’t apply, each trade will be treated as being the equivalent of taking your profits in USD… and thus you will owe taxes on that.

TIP: As an additional safe harbor, if one took gains this year from trading cryptocurrency to cryptocurrency, they can trade to another cryptocurrency at a loss the next time prices dip. This, assuming it is done correctly and avoids things like the 30-day rule (which can itself complicate things), should offset some gains for the year against losses (it won’t affect total tax liability in the future, just accounting for this year in the case that we find out like-kind doesn’t apply before the year’s end).

The implication: The takeaway here [assuming the theory above is correct] is that if you traded one cryptocurrency for another this year at a profit, you will owe taxes on that profit this year no matter what happens with your coin (unless you trade that at a loss or profit in the same year, in which case the rule applies to that too). The only way to offset taxes owed on profit from capital gains is to take a loss in the same year (a loss on any capital asset that counts toward the capital gains tax; not just cryptocurrency). So if you traded Bitcoin at $5k for Litecoin at $90 and made $10,000 in profit (not in that trade, but in general since you bought the Bitcoins), you owe taxes on your profits from Bitcoin at the capital gains rate (either short term or long term gains depending on when you bought). This is true even if Litecoin goes to zero. The only way out of that is selling your Litecoin at a loss in the same year (or trading it for another cryptocurrency at a loss). If you sell your Litecoin at a loss the following year, you can’t balance your losses from that year against your gains from the past year. You can balance independent capital gains and losses in a single calendar year, but you can’t balance them across calendar years in non-like-kind exchanges.

Bottomline: Until the IRS issues guidance, cryptocurrencies should not be treated as like-kind assets, one should assume the rules of like-kind exchange (1031 exchange) do not apply. One should thus assume that they can’t trade one cryptocurrency for another and defer gains and losses year-to-year that way. If you made gains in in cryptocurrency this year, and you traded that cryptocurrency for USD or any other cryptocurrency at any point, the safe bet (but hardly your only move) is to take your money out of cryptocurrency and put the taxable amount aside for the tax man (then re-enter the market next year). The only note is that other rules, like the 30-day rule, should apply (as they do for other investment properties).

General advice: The amount you should take out really depends on your investing strategy. If all your money is in cryptocurrency, you need to take out enough money to pay taxes, plus enough to cover the fees and the profits of taking out the money you are using to pay taxes (strange, but true; IRS doesn’t accept Bitcoin, so you need to pay in USD). If you only have a small portion of money in cryptocurrency, you can simply pay your taxes using the money in your bank. If cryptocurrency is down at the end of the year, consider selling at a loss. Taking a loss means paying less taxes (because you have less profit for the year). After 31 days you can reinvest in the same coin you cashed out of (see 30-day rule if you aren’t clear on this).

NOTE: As a general rule you can carry over capital losses of up to $3,000 in-between years. So if you mess up and owe profits from one year and take losses in another, you can still carry over losses against future profits.

NOTE: This is not legal advice or tax advice. This is a compilation of information relevant to cryptocurrency.

TIP: This means it is a better long-term bet to sit in a single cryptocurrency than it is to trade cryptocurrencies. If you want to be very safe, keep each cryptocurrency in its own wallet and keep tabs on each transaction. If you did anything other than hold a single cryptocurrency, consider consulting a tax advisor before the year end.

TIP: This is a big deal, if you don’t understand it, take the time to understand it.

While it is crystal clear, the IRS excludes assets treated as inventory or stock in trade from Section 1031 treatment, as would be the case where a 1031 is attempted by a bitcoin dealer or professional trader, making 1031 effectively unavailable, no explicit guidance has been issued to clarify whether one digital currency is “like kind” with another.

A taxpayer exchanging Euros for U.S. Dollars would not be able to rely on Section 1031 to defer any currency exchange gain and so it appears that the same could be said about exchanging one type of virtual currency for another.

– (RETRACTED) Is it Possible to do a 1031 exchange with Bitcoin, Ethereum, or other Electronic/Crypto Currencies? Published by David Klasing at April 3, 2017 and Virtual Currency and Section 1031 – A Retraction and New Position Published by David Klasing at September 1, 2017.

An Example of the Implications of Like-Kind Exchange Not Applying to Cryptocurrency

For an example of the implications of like-kind exchange not applying to cryptocurrency:

You can’t buy a bitcoin in 2017, trade it to litecoin in 2017, sell the litecoin in 2018, and then pay taxes on your total gains/losses then. You instead owe taxes each time a cryptocurrency is converted into another currency.

This means losses from future years can’t be written off against gains in past years.

In other words, each trade between cryptocurrency or cryptocurrency and USD is a unique taxable event. You can write off independent losses against independent gains in a year, but you can’t write off gains in one year against losses in another!

This can have some complicated tax implications where you can end up owing on profits in one year, but see those gains wiped out the next year, and then are unable to write off gains against losses because you are dealing with separate investments in separate tax years!

In other words, you could in the worst case, lose all your money and still get a giant tax bill if you trade a lot of cryptocurrencies over the course of a two year period.

If you are going to trade cryptocurrencies, consider every trade from cryptocurrency to cryptocurrency, or from cryptocurrency to USD, as its own transaction for tax purposes (each transaction from one coin to another is a taxable event).

You can write of capital gains and losses in a year (writing off real estate, against gold, against one cryptocurrency, against another cryptocurrency for example), but you can’t treat different cryptocurrencies as “like-kind properties” and defer gains and losses into another calendar year that way.

If you don’t understand that, but do trade currencies, take the time to brush up on 1031 exchange rules and cryptocurrency.

For another take on the subject, see: Virtual Currency and Section 1031 – A Retraction and New Position Published by David Klasing at September 1, 2017 or Cryptocurrency Traders Risk IRS Trouble With Like-Kind Exchanges.

TIP: This page is meant as a general overview. For official documents related to the IRS, cryptocurrency, and taxes see: Sales and Trades of Investment PropertyLike-Kind Exchanges Under IRC Code Section 1031, and IRS Virtual Currency Guidance : Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply. You won’t get a clear answer on cryptocurrency and like-kind exchange… and that is sort of the point of the page. That is, assume they don’t apply as a safe-harbor until further notice.

Citations

  1. Virtual Currency and Section 1031 – A Retraction and New Position Published by David Klasing at September 1, 2017
  2. Cryptocurrency Traders Risk IRS Trouble With Like-Kind Exchanges
  3. IRS Virtual Currency Guidance : Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply
  4. Sales and Trades of Investment Property
  5. Like-Kind Exchanges Under IRC Code Section 1031