Last Updated: September 25, 2020
This article was originally published on Forbes by Shehan Chandrasekera on January 6, 2020
In this post (part 5 of 6), we will take a deep dive into what’s covered under the “exchange” category of the crypto question on Schedule 1. It is a well established fact that crypto to crypto exchanges are taxable similar to sale of cryptocurrencies. If you had any crypto to crypto exchange transactions during 2019, you would have to check “yes” on the crypto question on Schedule 1. Speaking of crypto to crypto trades, one puzzling question to many crypto enthusiasts is why do you even have to pay taxes when you don't cash out the proceeds into US dollars? In this post, I will also explain the logic behind the taxation of crypto to crypto exchanges.
A crypto to crypto transaction occurs when you buy/exchange one cryptocurrency with another cryptocurrency. These transactions are very common among crypto traders because some alt coins can only be purchased using other major cryptocurrencies such as bitcoin (BTC) or ether (ETH). Let’s look at an example and break down the tax consequences. Say you purchased 1 BTC for $5,000 in February 2019. In March 2019, that BTC has appreciated to $7,000. On that day, you purchased ETH using that 1 BTC. 1 ETH is worth $100. After the transaction, you will have zero BTC and 70 ETH ($7,000/$100). This will trigger a short-term capital gain of $2,000 ($7,000 - $5,000). This is short-term because you exchanged (sold) the BTC within 12 months of acquisition. If you had held the BTC for more than 12 months, the resulting gains will be long-term and taxed at more favorable rates. Either way, the unfortunate part here is that you will have to pay taxes on this $2,000 even though you did not receive any cash. By the end of the year, If ETH price goes down from $100 per unit to $50, you will still have to pay taxes on the $2,000 gain despite holding a depreciated position.
Why Pay Taxes When You Didn’t Sell Anything?
For most people, the situation described above may sound illogical and unfair. So, let me explain how regulators see crypto to crypto transactions. Going with the example above, you receive 70 units of ETH which is worth $7,000 because you have a BTC which is worth $7,000 in March 2019. In the eyes of the regulators, what’s essentially happening here is that you “selling” your original $5,000 BTC for $7,000 and immediately using that proceeds to buy 70 ETH. In the process, you realized a gain of $2,000 ($7,000 - $5,000) and need to pay taxes on that. It does not matter what happens to the price of ETH after you purchase it. What matters is, at the time you purchased 70 ETH, your wealth had increased by $2,000; you accessed it by selling the original BTC. This recognition of wealth is taxed.
Like Kind Exchange (LKE)
Section 1031 of the tax code allows you to defer gains when you exchange a one property to another property with similar characteristics. This is a complex code section and subject to so many limitations and exceptions. Since cryptocurrencies are treated as “property” per IRS Notice 2014-21, some taxpayers applied this theory to defer gains when they bought one cryptocurrency using another. This allowed them to defer gains (not eliminate) until they sold the second cryptocurrency. If we were to apply the LKE treatment in our example, you will not have to pay taxes on $2,000 worth of gains in 2019. Instead, the gain will be deferred and added to the basis of ETH so your total cost basis of ETH will be $9,000 ($7,000 + $2,000). Therefore, you will only have to pay taxes when these 70 ETH get sold into USD in the future. Until then, your gains are completely tax sheltered.
Unfortunately, LKE treatment is not applicable to crypto to crypto transactions and the guidance issued on October 9, 2019 clearly says that exchange transactions are taxable (Q18 & Q19). Some taxpayers applied LKE treatment on tax returns filed before this guidance came out in 2019. The IRS has not publicly asked those taxpayers to correct the returns but its position is that LKE treatment should have never been applied to crypto to crypto trades.
Keep Money Aside For Taxes
Keep in mind that at the end of the year you will have to pay taxes in US dollars for gains you made in cryptocurrencies. Do not wait till the end of the year to cash out some of your crypto to cover your tax bill. If your position has gone down in value, this would not get you enough cash to cover your tax bill. Good rule of thumb is to cash out 10% - 20% every time you make a gain in cryptocurrency. If you trade frequently, you can look at your net gains every quarter and liquidate some crypto into USD to pay related taxes. This way you will not have to worry about the year end tax bill.
The “exchange” category of the crypto question is pretty straightforward. Make sure you check “yes” on the crypto question if you have any exchange transactions. Crypto to crypto exchanges are taxable, just like sales. These will be reported on Form 8949 and Schedule D. The most important thing to remember is that keep some money aside or liquidate a small portion of your position as you make gains to cover up your year end tax bill. In the next post, I will analyze the “financial interest” category of the crypto question.
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Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.