In a recent Chief Council Advisory, the IRS found that certain cryptocurrencies did not qualify as like-kind exchanges under section 1031 prior to the Tax Cuts & Jobs Act of 2017. The IRS’s ruling, while limited to coin exchanges involving Bitcoin, Ether, or Litecoin, provides insight on the IRS’s current thinking on the subject.
The ruling presented the following stated question: If completed prior to January 1, 2018, does an exchange of (i) Bitcoin for Ether, (ii) Bitcoin for Litecoin, or (iii) Ether for Litecoin qualify as a like-kind exchange under § 1031 of the Code?
The ruling set forth the following conclusion: No. If completed prior to January 1, 2018, an exchange of (i) Bitcoin for Ether, (ii) Bitcoin for Litecoin, or (iii) Ether for Litecoin does not qualify as a like-kind exchange under § 1031 of the Code.
Background on Virtual Currency
The IRS defines “virtual currency” as a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value other than a representation of the U.S. dollar or a foreign currency. Notice 2014-21; Rev. Rul. 2019-24. Virtual currency that has an equivalent value in real currency, or acts as a substitute for real currency, such as Bitcoin, is referred to as “convertible” virtual currency and is considered property for federal income tax purposes. Notice 2014-21.
Bitcoin, Ether, and Litecoin are all forms of cryptocurrency, a subset of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Rev. Rul. 2019-24 at 2. Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions. Cryptocurrencies may be used as a method of payment or for investment or other purposes.
Cryptocurrency exchanges are digital platforms that allow users to trade one cryptocurrency for another cryptocurrency, as well as for fiat currencies such as the U.S. dollar. Major cryptocurrencies like Bitcoin and Ether typically may be traded for any other cryptocurrency and vice versa. However, some cryptocurrencies on a cryptocurrency exchange can be traded for only a limited number of other cryptocurrencies and cannot be traded for fiat currency at all. In 2017, there were more than 1,000 different cryptocurrencies in existence.
Section 1031(a)(1) of the Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. The nonrecognition of gain or loss under § 1031 is intended to apply to transactions where the taxpayer’s economic situation following the exchange is essentially the same as it had been before the transaction. H. Rept. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B. (Part 2) 554, 564. The Tax Cuts and Jobs Act, P.L. 115-97, amended § 1031 to limit like-kind exchange treatment after December 31, 2017, to exchanges of real property. Prior to 2018, section 1031 also applied to certain exchanges of personal property.
Treas. Reg. § 1.1031(a)-1(b) defines “like kind” to mean the nature or character of the property and not the grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. For example, an investor who exchanged gold bullion for silver bullion was required to recognize gain in part because silver is primarily used as an industrial commodity while gold is primarily used as an investment. Rev. Rul. 82-166. Similarly, an investor who exchanged one kind of gold coin for another kind of gold coin was required to recognize a gain because one coin’s value was derived from its collectability while the other’s value was derived from its metal content. Rev. Rul. 79-143.
The IRS’s Rationale:
The IRS set out the following analysis with respect to the cryptocurrencies at issue in the ruling. To ensure that the reader get the first-hand account of the IRS’s current thinking on the subject, we will set out the relevant analysis from the ruling below:
BTC/LTC and ETH/LTC
In 2016 and 2017, Bitcoin, and to a lesser extent Ether, held a special position within the cryptocurrency market because the vast majority of cryptocurrency-to-fiat trading pairs offered by cryptocurrency exchanges had either Bitcoin or Ether as part of the pair. In other words, an individual seeking to invest in a cryptocurrency other than Bitcoin or Ether, such as Litecoin, would generally need to acquire either Bitcoin or Ether first. Similarly, an individual seeking to liquidate his or her holdings in a cryptocurrency other than Bitcoin or Ether, such as Litecoin, generally would need to exchange those holdings for Bitcoin or Ether first. In contrast, Litecoin’s trading pair availability at the time was substantially more limited.
Thus, Bitcoin and Ether played a fundamentally different role from other cryptocurrencies within the broader cryptocurrency market during 2016 and 2017. Unlike other cryptocurrencies, Bitcoin and Ether acted as an on and off-ramp for investments and transactions in other cryptocurrencies. Because of this difference, Bitcoin and Ether each differed in both nature and character from Litecoin. Therefore, Bitcoin and Litecoin (BTC/LTC) do not qualify as like-kind property for purposes of section 1031; nor do Ether and Litecoin (ETH/LTC).
As discussed above, Bitcoin and Ether shared a special role in the cryptocurrency market that made them fundamentally different from Litecoin during the relevant years. However, while both cryptocurrencies share similar qualities and uses, they are also fundamentally different from each other because of the difference in overall design, intended use, and actual use. The Bitcoin network is designed to act as a payment network for which Bitcoin acts as the unit of payment. The Ethereum blockchain, on the other hand, was intended to act as a payment network and as a platform for operating smart contracts and other applications, with Ether working as the “fuel” for these features. Thus, although Ether and Bitcoin may both be used to make payments, Ether’s additional functionality differentiates Ether from Bitcoin in both nature and character. Therefore, Bitcoin and Ether do not qualify as like-kind property under section 1031.
As one can see, the IRS places significant emphasis on the functionality of the cryptocurrency at issue in a proposed exchange. The Service characterizes Bitcoin and Ether, for example, as an “on and off-ramp for investments and transactions in other cryptocurrencies.” Litecoin, on the other hand, played a “fundamentally different role” from Bitcoin and Ether, differing in both “nature and character.” Viewed through this analytical prism, the Service concluded that an exchange of these cryptocurrencies did not give rise to a like-kind exchange.
The IRS likewise determined that Ether’s “additional functionality” caused it to be fundamentally different in both nature and character from Bitcoin, leading the IRS to hold that “Bitcoin and Ether do not qualify as like-kind property under section 1031.”
Taxpayers with cryptocurrency holdings should seek out advice and guidance from an experienced and credentialed tax attorney for guidance with respect to cryptocurrency transactions. Cryptocurrency activities and transactions present many opportunities for tax planning and, unfortunately, tax pitfalls. Given the IRS’s continued focus on cryptocurrency tax reporting, for many, the stakes can be high.