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Cryptocurrency traders once enjoyed a relatively regulation-free investment environment. Back in the early days of Bitcoin, only the most tech-savvy investors even knew it existed. As cryptocurrency creeps further into the mainstream, however, regulatory agencies are developing increasingly sophisticated policies regarding digital currency.
The Internal Revenue Service (“IRS”) first announced how and why cryptocurrencies are to be taxed with a brief policy statement in 2014. Much to the agency’s dismay, however, almost nobody has paid their taxes on digital currency investments. Now, the IRS is actively pursuing cryptocurrency investors who have failed to report their Bitcoin earnings.
We all reminisce about the good old days. After all, life was so much simpler for virtual currency investors when the IRS was in the dark about the billions of dollars being earned on cryptocurrency exchanges. Many investors still believe that cryptocurrency exchanges fall under loopholes in the tax code that exempt them from taxation. However, nothing can be further from the truth.
You may hear rumors within the cryptocurrency community that lead you to believe you can take advantage of tax loopholes to avoid paying taxes on your digital currency exchanges. Unfortunately, this is little more than wishful thinking. This article addresses some of these rumors and clarifies how and why they don’t work.
Evading taxes, even accidentally, can land you in serious hot water. However, smart tax planning can minimize your liability to the IRS.
1. Buying Cryptocurrency Through Your Retirement Account
Most of us know that retirement accounts like IRAs, 401-ks, or ROTH give tax breaks for people saving for retirement. As a result, some cryptocurrency investors believe that they can avoid paying taxes on their virtual currency exchanges by purchasing the assets through their retirement accounts. However, this is easier said than done.
If you are an American citizen or permanent resident and you want to buy cryptocurrencies through your IRA, you must first get a unique type of retirement account. It is often referred to as a self-directed or checkbook IRA (the most common one). You may also qualify for a self-directed 401k or SEP depending on our business structure. These types of accounts come with a variety of restrictions as well. There are several types of transactions that are expressly forbidden and completing any of them may invalidate your entire transaction. This will result in it being taxed as a distribution with additional penalties for early distribution tacked on as well.
You may even consider setting up one offshore, but this brings even more complications to the whole process and is usually avoided.
Sounds complicated? It is. You will definitely need the assistance of a profession. The process does have a significant cost to get started and requires some careful planning to be able to get the maximum benefit from it. You may also find yourself with a very limited number of exchanges that you can operate on as you will need to set up an institutional account and not a personal one.
Complexity, expense, and potential fraud are not the only problems with this scheme. Also, since this process requires you to become the manager for your own investment account, you’re not allowed to personally benefit from the investments. IRS rules prevent you from borrowing from the account or otherwise profiting from it personally, just like any other professional investment advisor. Furthermore, total annual contributions to your IRAs cannot exceed a combined $5,500 if you’re under age 50, and they’re capped at $6,500 once you’re older. Caps on some of the other plans are much higher but typically so is the paperwork.
They do have one place where they shine. If you are leaving a job where you had a 401k, you can potentially roll your 401k over into a self-directed IRA and then invest in cryptocurrency. Just make sure you practice good risk management and understand that values can crash quickly.
2. Buying Cryptocurrency Through Your Life Insurance Policy
Life insurance policies can have tax breaks similar to retirement accounts. For example, if you set up a private placement life insurance policy, hold it for a period of time, and then cash it out, you are entitled to tax deferral similar to a traditional IRA. You’ll still pay capital gains tax, but you can defer your tax liability until a later date. There’s no tax break, just a deferral.
But what if you never cash out your policy? If you hold virtual currencies in your life insurance policy until your death, it is passed to your heirs. Like other property conveyed through life insurance, your heirs wouldn’t have to pay taxes on any increases in the value of the virtual currencies held in the policy. Sounds great, right? After all, isn’t the whole point avoiding paying capital gains on your cryptocurrency earnings? Sure, except for one big problem: you’re dead. What’s the point of avoiding taxes if you’re never able to spend the money you’re trying to hide from the IRS? You might as well just give the IRS its cut and enjoy life while you’re still living it.
Leaving cryptocurrencies to your heirs sounds like a nice way to provide for your family after you’re gone. However, most private placement policies require an investment of at least $500 thousand before they will even begin the conversation. This minimum investment requirement excludes most of us from even attempting to jump through all the hoops necessary to participate in this scheme, so it’s better to save the time and heartache and just pay your taxes.
As cryptocurrencies continue to build wealth, this area will see a lot more attention as more and more investors will hit numbers that qualify for the minimums. Make sure you find a professional who truly understands these transactions to avoid getting hit with penalties.
3. Claiming the Like-Kind Exchange Exemption
In the 2014 IRS policy statement, the agency classified digital currencies as property. This led many investors to believe that swapping Bitcoin for other virtual currencies like Ethereum, Bitcoin Cash, or Ripple, qualifies as a like-kind exchange under Section 1031 of the tax code. A 1031 like-kind exchange involves trading one kind of business or investment asset for another. For example, if you own an art gallery and swap a painting that your customers detest for a sculpture you expect will draw a crowd, you pay no taxes on the exchange. Tax liability arises when you sell the sculpture, but so long as the two pieces of art are of the same nature of character you can defer paying taxes on the sculpture until it sells.
Investors who sold their cryptocurrency assets before 2018 often argue that they should be covered by the like-kind exchange exemption because cryptocurrencies have the same nature or character. However, this is not how the IRS treats virtual currencies. Dispensing of your Bitcoin – whether for U.S. dollars or other virtual currency – is a taxable event. This is true whether you buy a cup of coffee or the hottest new alternative coin. The transaction doesn’t qualify as a swap of property-for-property. Rather, it’s treated as a sale immediately followed by a purchase.
For investors planning to claim the like-kind exchange rule for cryptocurrency trades in the future, the 2018 federal tax reform has brought rain to the parade. Among the several changes to the federal tax code passed in the last days of 2017, Congress expressly limited Section 1031 exchanges to apply to real estate only. This closed the like-kind exchange loophole entirely, at least so far as it may have applied to cryptocurrencies in the past.
When in Doubt, Call a Professional
Most of us are relatively new to cryptocurrency. However, the IRS has had an eye on virtual currency transactions for several years now, and they aren’t letting anyone get away with evading taxes through perceived “loopholes” in the tax code. Early investors comforted themselves with the belief that they were protected by vagueness and uncertainty in IRS policy. However, these investors are now being pursued by the tax agency, which will most likely nail them with fees and penalties in addition to collecting the back taxes they owe.
When it comes to protecting your assets, keeping on the right side of the IRS is critical. Make sure to work with a licensed Certified Public Accountant who has received extensive training in virtual currency taxation.