On June 18, 2021, the IRS finally weighed in on whether cryptocurrency trades and swaps could qualify for like-kind exchange treatment before the Tax Cuts and Jobs Act (TCJA) limited section 1031 to real property. In IRS Legal Memo (ILM) 202124008, the IRS states its opinion that swapping certain cryptocurrencies for others cannot qualify for gain deferral on the basis that they are not like-kind to one another.
Background
Section 1031 allows taxpayers to defer the tax on gains when they sell certain property and reinvest the proceeds into similar property, commonly called like-kind exchanges. Starting in 2018, TCJA restricted section 1031 to real property and excluded all other types of property, whether tangible or intangible (and by extension, digital). Prior to TCJA, most types of property could qualify as long as the taxpayer bought property that counts as like-kind to what the taxpayer sold. To determine what qualifies as like-kind, Regulation section 1.1031(a)-1(b) states that "like kind" refers to the nature or character of the property and not to its grade or quality. There is a wide body of case law and IRS guidance interpreting how this could apply to different types of property. Virtually all U.S. real property counts as like-kind to all other U.S. real property, but the rules for personal property and intangible property are much more stringent. Accordingly, if cryptocurrency qualified for like-kind exchange before TCJA, the cryptocurrency sold must be very similar to the cryptocurrency purchased.
Taxpayers with cryptocurrency could rely on some established precedent in the form of decades old IRS guidance examining exchanges involving currency and precious metals. However, this guidance generally points to unfavorable results for crypto traders. For example, in Rev. Rul. 79-143, the IRS held that numismatic-type coins (i.e. coins deriving value from age, scarcity, history, aesthetics, etc.) are not like-kind to bullion-type coins (i.e. coins deriving value from metal content). In Rev. Rul. 82-166, the IRS held that gold bullion is not like-kind to silver bullion, because the value of silver is derived largely from industrial uses and the value of gold is derived largely from investment and speculation. These rulings demonstrate that the IRS continues to be skeptical of like-kind exchanges between different types of currency, even if the taxpayer acquired both for investments.
ILM 202124008
In ILM 202124008, the IRS examines trades in which taxpayers exchange between bitcoin, ether, and litecoin. The IRS describes each and determines that none of the three cryptocurrencies can qualify as like-kind to each other. The IRS cites to the revenue rulings on coins and precious metals as the foundation for analyzing the nature or character of cryptocurrencies, and uses similar arguments about how each derives its value and the underlying uses.
The IRS notes transactions to acquire litecoin generally require traders to give bitcoin or ether, and transactions to sell litecoin generally require traders to receive bitcoin or ether. Accordingly, the IRS concludes bitcoin and ether play a fundamentally different role in the market and differ in nature and character from litecoin. The IRS then explains that while bitcoin and ether may share a similar role in the cryptocurrency market, their underlying technologies make them differ from one another in nature and character. The Bitcoin network is designed to act as a payment network for which bitcoin acts as the unit of payment. In contrast, the Ethereum blockchain acts as a payment network and a platform for operating smart contracts and other applications, with the currency, ether, working as the ‘fuel’ for those features.
Bottom line for taxpayers
Using IRC section 1031 to defer gains from pre-TCJA cryptocurrency trades was already an extremely risky position. RSM has always cautioned taxpayers that section 1031 likely did not apply for most trades (Bitcoin tax: More than just reporting income). Even if the cryptocurrencies in question could possibly qualify as like-kind to one another, section 1031 contains very rigid requirements for structuring exchanges, as well as strict reporting requirements that crypto traders would have to follow to make a valid exchange.
While most cryptocurrency trades will not count as like-kind, this ruling does not necessarily close the door on all such transactions, and each must be examined independently. Members of Congress have periodically introduced or discussed legislation extending like-kind exchange to cryptocurrency, so there may be potential for different outcomes in the future. Note also that ILM 202124008 examines cryptocurrencies and transactions, as they existed in 2016 and 2017, when markets and technologies were very different. RSM strongly urges taxpayers who have deferred gains on cryptocurrency exchanges to consult their tax advisors about the potential risk. Check back for the latest news and analysis as RSM continues to monitor these developments.
