One perennial challenge faced by tax policymakers and regulators is that the real world changes much faster than laws and tax rules do. The latest sign of that cropped up last week, as the IRS announced it was sending 10,000 “educational letters” to taxpayers it suspects had taxable income from cryptocurrencies (such as Bitcoin) in 2018. This comes on the heels of a “virtual currency compliance campaign” the IRS conducted that year. The purpose of these letters is to encourage affected taxpayers to consider amending their tax returns to include this income.
In other words, “pay up or you might get an audit.”
What is a cryptocurrency? Brian Darling writing for Investors Business Daily has a good definition: “a cryptocurrency is an alternative form of currency from the traditional dollar. When held, it is a digital asset that uses peer-to-peer networks that create a blockchain ledger as a means to create a decentralized way to transfer value and record transactions. This digital asset has no intrinsic value, yet it has created a trustworthy system that many use as an alternative to traditional cash.”
How is a currency taxable? After all, using a debit card connected to your bank account to buy a cup of coffee isn’t considered a taxable event, so why is using a cryptocurrency to make purchases considered to be?
The answer is that the tax code doesn’t treat cryptocurrencies as currencies, as a mere means of exchange. Rather, it treats them as assets. Every time a cryptocurrency is exchanged, it is the equivalent of a capital gain or loss, like if you sold a stock. That requires taxpayers to keep track of every single cryptocurrency transaction, report basis, figure out gain, beware of traps such as the “wash sales” rule, etc. Imagine if you had to do that every time you went to the ATM for cash or bought a pack of gum at the store.
The best policy solution to this rather odd tax problem is for Congress to simply declare cryptocurrencies to be a means of exchange and remove the swapping of digital coins or tokens for other digital coins or tokens from the scope of the IRS. The IRS can and should do this by regulation, namely by repealing IRS Notice 2014-21, an Obama-era ruling that made cryptocurrency swaps taxable events.
Another very effective and commonsense plan has been introduced by Rep. Ted Budd, a Republican from North Carolina, H.R. 3963, the “Virtual Value Tax Fairness Act,” would permit cryptocurrency swaps to be included as a “like kind exchange.”
Think of a “like kind exchange” as a kind of tax-free rollover of property. If I own a rental home, and I want to sell it and invest the assets in another rental home, I can do so using a tax-free “like kind exchange” (also called “Starker exchanges” or “1031 exchanges”). Essentially, any money from the sale of the old home is rolled into the new home. Only when a taxpayer eventually cashes out is any tax due. While these exchanges are most commonly used in the buying and selling of buildings, they could also be used for any asset, even, famously, cattle. Prior to 2018, like kind exchanges could also be used for cryptocurrencies.
The Tax Cuts and Jobs Act of 2017 limited like kind exchanges to real estate only. Budd’s bill would create a second eligible property for 1031 exchanges, the swapping of cryptocurrency coins and tokens for other coins and tokens. This would allow users of cryptocurrency to avoid tax on a mere exchange of currency for other currency. While there would still be a reporting burden to the IRS, it would at least relieve cryptocurrency users of a nasty tax bill. Budd is to be commended for trying to help these taxpayers.
DAPnet, a nonprofit organization that advocates for better laws surrounding cryptocurrencies, says of the Budd bill, “the blockchain industry is still in its infancy, and different tokens and products should likely be taxed differently, whether they be security tokens, utility tokens or any of the new dynamic emerging products. Without temporary restoration of Like-Kind treatment, we will see tremendous overseas flight of America Blockchain and crypto companies to avoid the crippling tax burden and uncertainty in the United States.”
A recent survey from the industry shows that a third of all Americans are interested in buying Bitcoin, the most common type of cryptocurrency. But they fear the IRS and other regulators will make their activity too complicated to manage. The typical Bitcoin user makes less than $100,000 and lives in the suburbs with their family. Getting some certainty on tax compliance and payment will go a long way to getting the government out of the way of this startup industry.
Ryan Ellis (@RyanLEllis) is president of the Center for a Free Economy.
