Like-kind exchange is a topic fueled with such controversy that many tax professionals disagree on it.
In an article published on Cointracker, on November 15, 2019, Christopher Wrobel (Special Counsel to the Associate Chief Counsel, IRS) walked back Suzanne Sinno’s (General Attorney, IRS’s Office of Chief Counsel) comments from two days earlier at the AICPA National tax conference in Washington, DC.
Wrobel stated, “that while like-kind exchanges are disallowed for cryptocurrency starting in 2018, for pre-2018 transactions, they are still a grey area that will be decided on a case-by-case basis.”
This controversial topic has IRS lawyers in such a twist that they’re publicly editing one another.
IRS special counsel, Wrobel, says like-kind exchange is held on a case-by-case basis, and I currently have two crypto tax audit cases heading into review with the IRS special counsel.
We have written the legal briefs in the IRS’s hands right now with a reasonably compelling argument for like-kind exchange.
That puts Donnelly Tax Law on this controversial topic’s bleeding edge with two open audit cases containing significant arguments for like-kind exchange.
Like-kind exchange is no small tax savings strategy for crypto traders.
My firm, Donnelly Tax Law, has helped taxpayers owning cryptocurrencies to avoid taxes on over $40 million in gains by using Like-Kind Exchange calculations.
This article will explain how like-kind exchange works and how it saves big money on your crypto taxes.
What is like-kind exchange (LKE)?
Like-kind exchange (LKE) is the way most crypto traders agree cryptos should be taxed. You only are taxed when you convert back to cash. The U.S. tax law permitted this type of trading under section 1031, frequently called “like-kind exchange” (LKE).
An easy way to think of this is that the second property inherits the original property’s purchase price (basis) and purchase date during an exchange.
How does like-kind exchange (LKE) defer the gain until profits are taken?
Section 1031 allows the deferring of gain when exchange property.
For example, say you buy $2000 of BTC. When the value reaches $3000, you exchange the BTC for XRP. The gain of $1000 is considered deferred. The cost basis of XRP is the same as BTC or $2000. If XRP is later sold for $5000 in fiat USD, the gain would be $3000 because the cost basis is $2000, not $3000.
Like-kind exchange (LKE) treatment does not make the gain tax-free. The gain is deferred. It is eventually taxed as sold for fiat.
Deferring gain is important, especially when prices drop. Consider our example above. The price of our XRP holdings had collapsed to $2500. The gain when going to fiat would be only $500. The taxpayer is saved from having to pay tax on earlier gains, which later evaporated.
How do like-kind exchange (LKE) trades qualify quicker for long-term rates?
Since the second property inherits the first property’s purchase date, it qualifies for long term capital gain tax rates sooner when converting to fiat. Once a property is held for over a year, it qualifies for long term capital gains taxes, usually 15%. (Footnote 1)
How does like-kind exchange (LKE) reduce penalties and interest?
Here is where like-kind exchange (LKE) gets exciting for crypto traders.
Tax returns for 2014 to 2017 can be amended to report the like-kind exchanges without incurring an additional tax liability. This technique removes the audit risk of unreported crypto trades. There are no penalties or interest risk for reporting like-kind exchange (LKE) trades because there are no additional taxes owed.
The IRS charges an accuracy penalty and interest when it discovers unreported gains. Many customers come to me with unreported gains, especially for the 2017 tax year.
Would like-kind exchange (LKE) help me?
Like-kind exchange (LKE) is recommend for traders who need to report crypto-to-crypto trades before 2018. (Footnote 2)
Traders who would not benefit from like-kind exchange like-kind exchange (LKE):
One trader claimed he did crypto-to-crypto trades but turned out he always went back to cash before buying the next crypto.
One trader had huge crypto-to-crypto trade gains, but on December 28, 2017, he panicked and sold everything for cash. A day later, he reinvested all the cash back into cryptos. By cashing out, he had to recognize all the capital gains.
Why like-kind exchange (LKE) is the best way to report 2017 gains?
Consider this scenario: An investor buys 10 BTC on 1/1/2017 for $9600. On 12/21/2017, he exchanges the 10 BTC for 535 LTC at a fair market value of about $162,000. LTC price declines until he relents and sells all the LTC on 12/30/2018 for $17,000. Assume that the investor was in the 33% tax bracket in 2017 and the 32% tax bracket in 2018. Long term capital gains rate is 15%.
If the investor were to report each trade as capital gain, what is the tax impact?
Capital Gain Scenario: The investor pays $50,160 in taxes in 2017. But the gain of $152,000 is illusionary. In 2018, the market collapsed, resulting in a $145,000 loss. BUT, there is a $3000 limit on claiming a capital loss, so the capital loss carryover to 2019 is $142,000. The net tax burden over the two years for this transaction is $49,160.
Like-Kind Exchange Scenario: Under like-kind exchange, the investor pays no tax on the trade in 2017. The LTC inherits the original purchase price and purchase date of the BTC when treated as a like-kind exchange. This is shown in red down below. Although prices dropped in 2018, the selling price is still higher than the original price of the BTC, so there is a small gain. Since the holding period is extended because of like-kind exchange (LKE), the sale is taxed at lower long term gain rates. The net tax burden over the two years for this transaction is $1,110 or a savings of $48,050.
Amending Returns to add LKE: If this investor hadn’t reported his gains in 2017, amending his 2017 and 2018 returns results in a smaller tax using like-kind exchange (LKE). Also avoided are the substantial late payment penalty and interest on taxes.
Will using like-kind exchange (LKE) attract an audit?
Original filing of a like-kind exchange (LKE) return has never generated an audit for my clients.
Can a return be amended to use like-kind exchange (LKE)?
I have filed dozens of like-kind exchange (LKE) returns without audit. The only time I have difficulty is when a large refund is claimed on an amended return. This gets an extra review, but you should still get it if you are entitled to a refund.
One client was selected for audit, but this was related to unreported K-1 income.
Is using like-kind exchange (LKE) legal?
In December 2017, Congress passed the TCJA tax law, which modified Section 1031, limiting like-kind exchange (LKE) to only real estate. Over the prior decade, section 1031 was used for more purpose to defer gain. There was a debate; it was time to limit the application of 1031. It was not because of cryptocurrencies alone that it was changed.
The law only applies to tax years 2018 and forward. The law doesn’t apply to prior years. The law change has no implications for the legality of non-real estate like-kind exchange (LKE) trades in prior years.
If you are looking for some formal IRS document that says like-kind exchange (LKE) is permitted for cryptocurrency trades, it doesn’t exist. It will never exist. The IRS tries to educate taxpayers on what the tax law and regulations specifically say. They leave the application up to you.
Stay tuned, or subscribe to my newsletter, for my next post where I 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.
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Footnote 1: 20% if you are in the top tax bracket.
Footnote 2: At the end of 2017, Congress changed Section 1031 to only apply to real estate