On Sept. 13, 2021, the House Ways and Means Committee released text for proposed tax initiatives (The Initiatives) to be included with the Build Back Better Act, which is a larger budget reconciliation bill. The Initiatives released earlier this week target wealthy corporate entities and individuals to help raise tax revenues in order to help pay for the $3.5 trillion package of proposed programs set forth by the Biden administration in the Build Back Better Plan. For a broader analysis of all of the relevant provisions see our Tax Alert: House Ways and Means releases reconciliation tax payfors.
Along with the proposals to increase the corporate tax rate from 21% to 26.5% and the long-term capital gains rate from 20% to 25% for “certain high income individuals”, the bill also targets digital assets to help raise tax revenues. The Initiatives propose to apply wash sales and constructive sales rules to digital assets. If the initiatives are passed, the provisions relating to wash and constructive sales would apply starting Dec. 31 of this year, whereas the hike in capital gains rates for certain high income individuals could go into effect as early as Sept. 13, 2021 (depending on whether the transactions were initially entered into before or after the proposed Initiatives).
Wash sales rules
The wash sales rules are anti-abuse rules governed by section 1091 and were created to prevent taxpayers from selling stocks or securities at a loss with the sole purpose of benefitting from a tax benefit in order to offset some other gain. The rules under section 1091 would be triggered if a taxpayer were to sell a stock or security at a loss and then purchase “substantially identical stock or securities” within 30 days of the sale. Wash sales have traditionally been applied to stocks and securities, options and short sales under the Code, but have not applied to digital assets, which have been defined under Notice 2014-20 as property (refer to Bitcoin tax: More than just reporting income).
Under the proposed Initiatives, wash sale rules would apply to digital assets as of Dec. 31, 2021. If the wash sales rules were triggered for a digital asset, the loss under section 165 would be disallowed. However, under section 1091 and the related regulations, the taxpayer would be able to add the value disallowed loss to the basis of the newly acquired substantially similar digital asset, which would then reduce the gain of the newly acquired digital asset when disposed of later. Additionally, the holding period would be inclusive of the original digital asset held under section 1223(3).
Token A was purchased on Jan. 1, 2020 for $10,000 and sold Jan. 1, 2022 for $8,000 creating a loss of $2,000. On Jan. 15, 2022 the taxpayer purchases a substantially similar asset, Token B, for $8,000. Under the wash sales rules, the $2,000 loss would be disallowed and the taxpayer would add the loss to the basis of the currently held digital asset. Thus, the basis for Token B would be $10,000 and the holding period would start on Jan. 1, 2020.
Constructive sales rules
The constructive sales rules are also anti-abuse rules and are governed by section 1259. These rules were created in 1997 in order to curtail positions known as short sales against the box. A short sale against the box means that the investor is shorting stocks that he already owns while maintaining a long term position until the time is right to sell (where a ‘long’ position would mean purchasing a stock in the hopes that that value will rise and sell for a profit later and a ‘short’ position would include speculating that a value would decrease, so the investor borrows a security to sell on the market with the intent to buy back later for a lower amount). The constructive sales rules were meant to deter certain investors (e.g., hedge funds) with appreciated financial positions from circumventing short term capital gains rates by acquiring investment gains without paying any capital gains. The rules also aim to limit the ability to transfer gains from one year to the next.
When the constructive sales rules were first created, an appreciated financial position meant that the taxpayer had an interest in an appreciated stock, debt instrument or partnership interest. This may also include digital assets (e.g., Bitcoin, Ethereum, NFTs), starting on Dec. 31, 2021 if the Initiatives are signed into law. The constructive sales rules apply when a taxpayer in an appreciated financial position enters into a short sale with substantially identical property. In this case, the taxpayer would recognize gain as if the position were sold at fair market value and the basis in the digital asset would increase to the fair market value paid due to the constructive sales rules. Unlike the wash sales rules, there would be no tacking on the holding period and the holding period would restart on the day the constructive sale gain was recognized.
Token A was purchased on Dec. 1, 2021 at $100. Oct. 21, 2022 Token A is now valued at $1,000. Investor wants to wait the full 12 months to get long term capital gains rates but is afraid that the token will decline in value. Investor enters into a short position against his token on Oct. 22, 2022. This would trigger the constructive sales rule and the investor would need to pay short term capital gains rates on the gain ($900). The basis in Token A would now be $1,000 and the holding period would start on Oct. 22, 2022.
Impact on taxpayers owning digital assets
The proposed Initiatives could have significant adverse tax consequences for taxpayers who own digital assets. The provisions in the Initiatives related to digital assets alone are expected to generate $16 billion in tax revenue. The House is expected to vote on these initiatives sometime around the end of September or beginning of October. Taxpayers who own digital assets should consult a tax advisor to see about the potential tax consequences of future sales and existing short positions. High-net-worth individuals with digital asset holdings in particular should be mindful of these tax consequences as they could potentially be subject to an increased capital gains rate of 25% along with a net investment income tax rate of 3.8% in addition to wash and constructive sales rules. RSM has a robust digital asset practice and would be able to provide tax guidance on these matters.