Applying the like-kind exchange treatment is a controversial position in crypto taxation, where exchanging one cryptocurrency for another qualifies for tax-deferred treatment under IRC section 1031.
In my previous article, I explained how Donnelly Tax law is on the bleeding edge of like-kind exchange (LKE) with two open audits being reviewed by the IRS.
I explained how like-kind exchange (LKE) could save crypto traders a lot of money on their crypto tax bill.
Today, I will lay out the legal case for like-kind exchange (LKE) by exploring the controversial position that exchanging one cryptocurrency for another qualifies for tax-deferred treatment under IRC section 1031.
IRC Section 1031: Cryptocurrencies Are A Specific Class Of Property
26 CFR 1.1031(a)-2 states the “nonrecognition rules of section 1031 do not apply to an exchange of one kind or class of property for property of a different kind or class.” The asset classification rules of 1.1031(a)-2(b) do not apply to cryptocurrencies because they are not tangible property. There are no classes for intangible property. (Footnote 1)
Interestingly, IRS Notice 2014-21 classified all cryptocurrencies as “convertible virtual currencies,” a sub-class of virtual currencies which satisfies the requirement that exchanged property be of the same kind or class.
IRC Section 1031: Cryptocurrencies Differ Only In Grade Or Quality, Not Nature Or Character
In determining when a property is of like kind, “The words like kind have reference to the nature and character of the property and not to its grade or quality,” according to 26 CFR 1.1031(a)-1(b).
With regard to intangible property, the regulations state:
“Whether intangible personal property is of a like kind to other intangible personal property generally depends on the nature or character of the rights involved (e.g., a patent or a copyright) and also on the nature or character of the underlying property to which the intangible personal property relates.” (Footnote 2)
The nature and character of a cryptocurrency are that it is a digital store of value using bytecode recorded on a blockchain using a cryptographic method. Variations in bytecode instruction set or blockchain protocols are just matters of grade or quality.
When the IRS determined that the exchange of an FCC license for a radio frequency was a like-kind exchange for a television frequency, they stated:
“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. Thus, we find that the differences in the assigned frequencies are not differences in nature or character, but are merely differences in grade or quality.” (Footnote 3)
Five years later, A similar conclusion was given by the IRS regarding matters of grade or quality:
“We note that the bandwidth of a particular frequency dictates the amount of information that the frequency can carry. In comparing the nature or character of the assigned frequency of the electromagnetic spectrum referred to in each FCC license, it is clear that the spectrum rights transferred by the Taxpayer have different bandwidths from the spectrum rights received by the Taxpayer. However, 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. As stated earlier, the spectrum rights being transferred by the Taxpayer to AA and the spectrum rights being received by the Taxpayer from AA are all suitable for use in the Taxpayer’s business of providing Services. Thus, we find that the bandwidth differences in the spectrum rights being transferred and being received in this exchange, which underlie these FCC licenses, are not differences in nature or character, but are merely differences in grade or quality, and thus constitute like-kind property.” (Footnote 4)
IRC Section 1031: Pre-TJCA Wording Of Section 1031
The TCJA amended the wording of section 1031 primarily by limiting section 1031 to only apply to real property effective January 1, 2018. In Appendix 1, I have reconstructed the pre-TCJA wording of section 1031.
Cryptocurrencies Are Held For Investment Purposes
Cryptocurrencies reported were held for investment purposes, according to IRC 1031(a)(1). This is the primary motivation for owning cryptocurrencies.
Exception For Property Held For Sale Doesn’t Apply To Cryptocurrencies
IRC 1031(a)(2) does not prohibit like-kind exchange between cryptocurrencies because cryptocurrencies are not one of the listed exceptions. Clearly, cryptocurrencies are not forms of stock-in-trade, property held primarily for sale, stocks, bonds, notes, interests in partnerships, certificates of trust or beneficial interests, or choses in action.
Cryptocurrencies do not qualify as “other securities”. This IRS code section doesn’t provide or refer to a definition of “other security”. The IRS has not issued any direct guidance regarding the issue of whether cryptocurrency is a security.
The Security and Exchange Commission (SEC) issued a 2017 report on cryptocurrencies. The SEC uses a four-prong test, known as the Howey test, to determine if a property is a security: “A [security] is [1] an investment of money [2] in a common enterprise [3] with a reasonable expectation of profits [4] to be derived from the entrepreneurial or managerial efforts of others.” (Footnote 5) The advancement of cryptocurrencies are not related to the ongoing entrepreneurial or managerial efforts of other persons, but rather to consensus algorithms.
IRC Section 1031: Procedural Requirements For Completing Section 1031 Exchanges
- IRC 1031(a)(3) requires that property to be exchange be identified and the exchange happen within certain time limits. Exchanges on cryptocurrency exchanges are instantaneous. The property given up and the property received are clearly identified at the time of the exchange.
- IRC 1031(b) and (c) don’t apply on cryptocurrency exchanges because only cryptocurrencies are exchanged and no other property.
- IRC 1031(f) regarding related persons is not applicable because on cryptocurrency exchanges, the parties are anonymous to each other because they are matched up by an exchange. After the transaction, both parties remain anonymous. The possibility that a transfer would occur between related parties would be coincidental, unintentional, and unknown to the parties.
Receipt Of Other Property
The nature of online exchange of cryptocurrency is that they match buyers and sellers for exchanging assets without any other property as described in 1.1031(b)-1.
IRC Section 1031: Summary
The exchange of cryptocurrencies for other cryptocurrencies are like kind exchanges under IRC 1031 as supported by IRS Technical Advice Memorandums.
There are additional court cases that can be added to the evidence in favor, but this short article lays out the key issues.
Stay tuned for the next article where I will discuss why the old law is still relevant.
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Footnotes
- 26 CFR 1.1031(a)-2(c)(1)
- 26 CFR 1.1031(a)-2(c)(1)
- IRS Letter Ruling 200035005, May 11, 2000.
- IRS Letter Ruling 200532008, May 9, 2005.
- See SEC v Edwards, 540 U.S.389, 393 (2004); SEC v W J Howey Co., 328 US 293, 301 (1946); United Housing Found, Inc v Forman 421 US 837, 852-53(1975)
Appendix 1: Pre-TCJA Wording of 26 USC 1031
26 U.S. Code § 1031.Exchange of property held for productive use or investment
(a)Nonrecognition of gain or loss from exchanges solely in kind
(1)In general
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.
(2)Exception for property held for sale
This subsection shall not apply to any exchange of—
(A) stock in trade or other property held primarily for sale,
(B) stocks, bonds, or notes,
(C) other securities or evidences of indebtedness or interest,
(D) interests in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.
For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.
(3)Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property
For purposes of this subsection, any property received by the Taxpayer shall be treated as property which is not like-kind property if—
(A)
such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the Taxpayer transfers the property relinquished in the exchange, or
(B)such property is received after the earlier of—
(i)
the day which is 180 days after the date on which the Taxpayer transfers the property relinquished in the exchange, or
(ii)
the due date (determined with regard to extension) for the transferor’s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.
(b)Gain from exchanges not solely in kind
If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
(c)Loss from exchanges not solely in kind
If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized.
(d)Basis
If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the Taxpayer and increased in the amount of gain or decreased in the amount of loss to the Taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the Taxpayer another party to the exchange assumed (as determined under section 357(d)) a liability of the Taxpayer, such assumption shall be considered as money received by the Taxpayer on the exchange.
(e)Application to certain partnerships
For purposes of this section, livestock of different sexes are not property of a like kind.
(f)Special rules for exchanges between related persons
(1)In general
If—
(A)
a taxpayer exchanges property with a related person,
(B)
there is nonrecognition of gain or loss to the Taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and
(C)before the date 2 years after the date of the last transfer which was part of such exchange—
(i)
the related person disposes of such property, or
(ii)
the Taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the Taxpayer,
there shall be no nonrecognition of gain or loss under this section to the Taxpayer with respect to such exchange; except that any gain or loss recognized by the Taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.
(2)Certain dispositions not taken into accountFor purposes of paragraph (1)(C), there shall not be taken into account any disposition—
(A)
after the earlier of the death of the Taxpayer or the death of the related person,
(B)
in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or
(C)
with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.
(3)Related person
For purposes of this subsection, the term “related person” means any person bearing a relationship to the Taxpayer described in section 267(b) or 707(b)(1).
(4)Treatment of certain transactions
This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.
(g)Special rule where substantial diminution of risk
(1)In general
If paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f)(1)(C) with respect to such property shall be suspended during such period.
(2)Property to which subsection applies
This paragraph shall apply to any property for any period during which the holder’s risk of loss with respect to the property is substantially diminished by—
(A)
the holding of a put with respect to such property,
(B)
the holding by another person of a right to acquire such property, or
(C)
a short sale or any other transaction.
(h)Special rules for foreign real and personal property
Real property located in the United States and real property located outside the United States are not property of a like kind.
(i)
For purposes of subsection (a)(2)(B), the term ‘stocks’ shall not include shares in a mutual ditch, reservoir, or irrigation company if at the time of the exchange—
- the mutual ditch, reservoir, or irrigation company is an organization described in
- section 501(c)(12)(A) (determined without regard to the percentage of its income that is collected from its members for the purpose of meeting losses and expenses), and
(2) the shares in such company have been recognized by the highest court of the State in which such company was organized or by applicable State statute as constituting or representing real property or an interest in real property.”
