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1031 Exchange: Risky Business

1031 Exchange: Risky Business

In the crypto world, a popular pre-2018 tax deferment strategy involved classifying ICO investments as a 1031 exchange. An investor would put cryptocurrency into an ICO and hold it for 366 days and then file taxes as if it was holding a home for a year and a day. However, the 2018 tax bill specifically forbids this practice. That means that claiming this practice in 2017, which was never explicitly allowed, would be a risky and aggressive practice. A CPA would likely be pretty nervous about this tax treatment - so you should be too.

While many in the corporate world were ecstatic when the most recent tax bill was approved in Congress, participants in the Crypto world were not so pleased. At the core of their anger and confusion is a change to the language of Section 1031 of the Federal Tax Code which functions to eliminate the possibility of cryptocurrency trades qualifying as “like-kind” exchanges. 1031 Exchanges are very important in taxes as their proper use can save money that can be then be reinvested. With this tax bill, some leading lawyers like Suzanne Walsh explain that the 1031 Exchange strategy can now truly only be used for real estate.

Generally speaking, the tax code requires investors to report transactions as taxable events only when a “realization event” (a transaction that locks in a gain or loss on a capital asset) occurs. For instance, in the exchange from Bitcoin (BTC) to Ripple (RPX), arguably no realization occurs because the investor has yet to materialize the gain or loss in US Dollars terms, thus making the trade a non-taxable event. To aid this claim, investors pointed to Section 1031 of the Tax Code (“Exchange of Real Property held for productive use or investment).

For the uninitiated, a Section 1031 “like-kind” exchange allows investors to defer capital gains taxes when selling certain types or property held for investment. The relinquished property must be traded for replacement property of the same character rather than trading the property first for cash and then converting the cash into the new property. While stocks, bonds or notes, and other securities or evidence of indebtedness/interest are specifically excluded from the 1031 definition of eligible property, commodities such as gold, silver, and art are eligible (at least prior to 2018).  

Thus, relying on 2014 IRS issued guidance  declaring cryptocurrencies as “property,” but not of the kind specifically prohibited in the regulations, those wishing to defer paying taxes on crypto to crypto exchanges placed the transaction within the scope of section 1031 and were thus allowed to transfer the “cost basis” original value of an asset for tax purposes.

However, diving into the nuances of the law reveals the argument may not hold weight. For instance, “one kind or class of personal property may not be exchanged on a tax-free basis for personal property of a different kind of class?” One major problem is what constitutes a “different kind of class within the crypto ecosystem – is the differing use cases of Ethereum and Ripple enough to make each of a “different class” than Bitcoin? Is a Stablecoin “of a different class” than Utility Tokens?

Furthermore, another requirement of 1031 Exchanges is the presence of a “qualified intermediary” to facilitate the exchange (See Treasury Reg. 1.1031(k)-1(g)(4)(iii) for a definition of qualified intermediaries). Unfortunately, it is unclear whether cryptocurrency exchanges can be categorized as qualified intermediaries. And now, this may apply to past tax years, as well.

In conclusion, no definitive answer exists one way or the other. The IRS perhaps tipped its hand by lobbying Congress to include changes to the Section 1031 language in the recent tax bill, but again, no definitive guidance has been issued. Ultimately, our advice to those attempting to apply Section 1031, even retroactively, to their crypto-asset trading activity is to consult a lawyer.

Drew Nordstrom is the President of Zenledger.io. He has a BA Economics, Chapman University; MA in Political Economy, University of Manchester (UK); JD/MBA ’18 Seattle University. 

Note: Zenledger.io is a software company. We do not want to offer judgments or advice on any of these issues and recommend you consult a lawyer and a CPA if attempting to apply Section 1031 like-kind exchanges to pre-2018 crypto to crypto swaps. 

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