The IRS created a wave of uncertainty in 2014 when they decided to treat Bitcoin and “convertible virtual currency” as property. Three years later, the SEC’s decision to start treating ICO tokens as “Securities," apparently on a case-by-case basis, may have created the second wave of unknowns in the tax sphere.
Crypto Tax Blog Part I-A, Appendix A
Your ICO Tokens may be “Securities”, does it impact your U.S. Taxes?
General – Crypto is Property (2014)
According to the IRS Notice 2014-21 on crypto currency, for U.S. federal income tax purposes, a convertible virtual currency (“CVC”) is treated as property (Q&A 1). Bitcoin is the clear example of this definition. The IRS code requires each U.S. citizen to report a gain or loss on the personal income tax return when investment property is later sold for U.S. dollars, or exchanged for other property (except for the “like-kind” exception).
The general impact of investing in crypto is outlined in detail in Part I-A of the blog (link below):
SEC – Certain ICO Tokens are Securities (2017)
The SEC determined that for purposes of securities law, the virtual currencies that are sold through certain Initial Coin Offerings (ICO’s) could be treated as securities.
In the U.S. tax code, in addition to the rules for selling/exchanging “property”, there are even more rules of selling “securities.”
A few tax implications are significantly impacted by the “securities” classification if the IRS adopts a consistent definition with the SEC on a token-by-token basis: (1) Basis Tracking, (2) Wash Sales (3) and Like-Kind Exchanges.
Note: It is possible (but not certain) that in the future the tax implications of all convertible virtual currency sales/exchanges (not just SEC-designated securities) are codified to be consistent with buying/selling stocks/securities. There seems to be no clear guidance yet as this is a developing area.
Easier Basis Tracking
For convertible virtual currency that is not a security, specific identification of the cost of virtual currency that is acquired/sold is necessary in order to report gain/loss on each sale. This means, if a U.S. person buys 1 BTC for $1,000 USD on Day 1, buys another 0.4 BTC for $1,200 USD on Day 2, and then sells 0.6 BTC for $1,500 USD on Day 3, the amount of BTC that is sold (0.6 BTC) technically needs to be traced back to the original acquired BTC. There are helpful websites out there than can help you trace specific buy/sells; but at the end of the day, this tracking still requires significant record-keeping, meaning your time, effort or money. Of course, down the road, maybe exchanges become responsible for basis reporting, as are brokers with stocks.
For securities, a U.S. person normally will use a first-in-first-out (FIFO) method to determine the cost basis for a sale/exchange. This means the earliest securities purchased is treated as sold first, and the most recent purchases remain.
For example, if a U.S. person buys 1 security for $1,000 USD on Day 1, buys another 0.4 security for $1,200 USD on Day 2, and then sells 0.6 security for $1,500 USD on Day 3, the basis would be applied on a FIFO basis. The amount of basis used in the sale of 0.6 security would be based on the basis in the Day 1 purchase (basis = 0.6 sold X Day 1 basis for 1 security of $1,000 = $600). The gain is $1,500 - $600 = $900.
Again using FIFO, if on Day 4, 0.5 security is sold for $1,200, then the basis used in the Day 4 sale is (a) basis of the remaining 0.4 security from Day 1 (0.4 x Day 1 basis for 1 security of $1,000 = $400 basis), plus (b) 0.1 of the Day 2 basis (0.1 X $3,000 per 1 security, the effective price paid in Day 2 for 0.4 security) = $300 basis; for a total basis of $700 ($400 plus $300). The gain would be $1,200 – $700 = $500.
There is also a weighted average method for basis tracking, in addition to the FIFO method, and, as with all tax law, other rules/exceptions.
Wash Sale Rule
If securities are sold at a loss, and then re-purchased within a 61 day window starting 30 days before the sale, or 30 days after the sale, then the loss on the initial sale is usually disallowed. The cost basis of the new securities purchased is the new price paid plus the loss on the first sale that was not allowed; this is so that the basis in the securities held are the same as if the securities were never even sold in the first place. There are some nuances when the stock is held in retirement accounts (i.e. IRA’s), and exceptions for property received by gift/like-kind exchange, etc.
It is unclear whether a wash sale rule will eventually apply to all crypto currency transactions, but we can expect for now, the rule applies to any ICO tokens the SEC deems securities.
Note: Different rules to traders with a mark-to-market election.
Like-Kind Exchange
A gain loss generally isn’t recognized on the exchange of property held for investment (or business use) for new property that is a similar nature/character. The tax rules of like-kind exchanges of convertible virtual currency were unclear enough, without adding “security” issues to the mix (a detailed article coming this week, which tables the security discussion as it is addressed here).
Like-kind exchanges usually do not apply to stocks, bonds, notes or other securities (1.1031(a)-1(ii) & (iii)). Should we expect then, using Bitcoin to get into the ICO is likely a taxable event if the ICO token is deemed a security by the SEC? Note, as you will see in my upcoming article, this type of exchange is a possible taxable event, even when the ICO token is not a security, due to not being a like-kind exchange of similar property.
Considerations for Hard Fork of an ICO Token
For a token treated as a security, would a new rule be codified that the hard fork of such token would be a nontaxable distribution, similar to existing rules for a nontaxable distribution of corporation stock (or a stock right) under Section 305?
Under Section 305/307, a shareholder is generally not taxed on the receipt of a proportionate distribution of corporation stock (i.e. a stock split) . Further, the rules require the shareholder would allocate their cost basis between the original stock and new stock in proportion to their fair market values. However, if the new stock value is less than 15% of the original stock, the U.S. person would just take a zero basis in the new stock/right, and not disturb the original stock’s basis.
These outcomes for corporation stock under 305/307 are in line with Scenario A and D examples as potential applications of the tax law to hard forks of convertible virtual currency (from my Part II article below):
Note: There would be many unknowns the IRS would need to address if a rule similar to 305/307 is made for convertible virtual currencies that are treated as securities. For example, both the original virtual currency and the forked currency would have to meet the “convertible virtual currency” definition. Further, if the forked currency was treated as just a dividend of property (not also a SEC “security”), then the consequences could be much different. The correct application of the law is unknown at this time at this time, so I would not take personal reliance on the examples above as it is pure 100% speculation based on existing tax laws.
Takeaway
There are many unknowns in the correct treatment of crypto currency as the complexity of transactions increases. The SEC “security” designation for ICO tokens makes the situation even unclear.
If you have any thoughts please feel free to share, I would love to hear everyone’s thoughts on the subject!
Disclaimer
This series contains general discussion of U.S. taxes in an unclear and developing area of tax law. As always, you should consult your own tax advisor in your jurisdiction to determine your specific situation as this is not personal advice; and consider any future guidance by the Congress/IRS after the date of this article. Under Circular 230 to the extent it applies, this article cannot be used or relied on to avoid any tax or penalties in the U.S., its States or any other jurisdictions.
Photo Credit
https://pixabay.com/en/users/geralt-9301/