An in-depth look at the Like-Kind Tax Issue

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  • Source: Dapnet
  • 08/26/2019
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The 2018 new tax law's changes, effective this past January 1st, narrowed the coverage of the like-kind exchange to exclude personal property (including bitcoin and other digital units, also called cryptocurrencies). Below is a summary of the various adverse effects, followed by a background on current regulatory treatment. 

BACKGROUND. 

The recently-enacted federal tax reform bill unintentionally but seriously harms America's "blockchain technology" industry. This industry, and the technology, are at the cutting edge of the broader "information management" and "financial services" sectors, but have only gotten widespread attention (at least in the financial press) because of the recent, rapid increase in the value of various blockchain-based computer code protocols, which to the world are known as "bitcoin" and other, lesser-known "altcoins" (including Ethereum). 

The tax bill's adverse effects arise from its revisions to Section 1031 (the like-kind property exchange section) of the Internal Revenue Code restricting the application of that section to cover qualifying exchanges (in which a disposition and subsequent purchase occur generally within 30 days) of only real property, but not personal property. 

The impacts, though, are serious: 

Effective double taxation of blockchain transactions whose economic reality is a purchase, as well as a sale;
Tax treatment causing much higher and disproportionate recordkeeping burdens on taxpayers; and
A deterrent impact on all blockchain-based activity resulting from the foregoing impacts.

MORE BACKGROUND

What Do You Call This Stuff? The relative novelty of the technology, unfamiliarity of most observers with the technology or its uses, and widely-differing terminology employed by commentators, regulators and industry participants requires a brief explanation of existing nomenclature and then of our choice of nomenclature. 

There are various terms used to describe different digital protocol units: bitcoin, cryptocurrency, digital currency and so on. Almost all of these units are blockchain-based assets comprised of code, representing data, which is contained within the "hash" of a block (the unit) that is mathematically related to all blocks which precede and follow it on a linear activity record called a "blockchain." The technology is still new and there is no legally accepted definition; the most popular (if not necessarily the most accurate) terms are "cryptocurrency" and "digital currency." 

The Internal Revenue Service has issued guidance in March 2014 (see below) referring to these units as "virtual currency" and holding that it would treat them as "property" and not as "currency," its own nomenclature notwithstanding. (On a related note, we strongly believe that digital units have uses and value that go far beyond any contemplated use as a medium or store of value or exchange.)

For ease of reference in this communication, and in deference to the IRS not treating these units as "currency," we refer to the general class of these protocols as "digital units" and avoid any terms which derive from or incorporate the word "currency" (e.g., digital currency, virtual currency, cryptocurrency).

IRS Treats This As Property. The subject of digital units is not new to the Internal Revenue Service. As stated above, the IRS has already issued guidance in 2014 (available at https://www.irs.gov/pub/irs-drop/n-14-21.pdf) declaring that assets it calls "virtual currency" are to be taxed as property, and not as currency. (For the limited purposes of this discussion, we avoid revisiting the debate over digital units are properly taxed as "property" when they are increasingly viewed in the world at large as "alternative currencies" which are used as media for exchange, even though their non-currency applications are being increasingly deployed and their potential increasingly understood.) 

Section 1031. This section has allowed taxpayers disposing of property to defer tax on the sale of said property if they engage in a subsequent purchase of a 'like kind' asset, i.e., United States property, generally within 180 days. However, the recent tax code revision to Section 1031 restricted its scope to "real property" by merely adding the adjective "real" to modify "property" where it appears in the statute. Before the revision, the section referred to "property" without distinction between personal property and real property. (A third party real estate industry webpage briefly explaining this is accessible here.) 

THE UNREASONABLE AND SERIOUS IMPACT OF THE NEW TAX LAW

This change threatens several adverse, disproportionate and unwarranted impacts on the digital asset / blockchain development community and industry. However, it is helpful to understand that current tax law (notwithstanding the Section 1031 change) already penalizes the use of digital assets in consumer commerce. 

An Effective Sales Tax Of Nearly 40% Penalizes The Use of Digital Units In Commerce. The use of digital assets (e.g., bitcoin) is already treated as a "sale" of the asset, even though the economic reality of the transaction is a purchase of a consumer good. In fact, for knowledgeable consumers and digital asset holders, the use of digital units would be very strongly deterred by this tax change. A consumer using bitcoin to buy a flat-screen TV set (or any other consumer good) faces double taxation: first, a sales tax (in many states) on the purchase, and second, a capital gain on the bitcoin used for the purchase. In some states, that taxpayer could be facing an effective sales tax of nearly 40% (after accounting for the short-term capital gains rate, the 3.8% capital gains surcharge on certain higher-income taxpayers imposed as part of the Affordable Care Act, and sales taxes in many states such as New York, New Jersey and Connecticut of 7% or higher). Such tax treatment does not merely deter, discourage or punish using digital units in regular commerce. It seeks to virtually prohibit it.

Any Use of The Blockchain Can Result In A Tax. Starting in 2018, virtually any use of digital assets become taxable events even when it is clear that the economic substance of the activity does not involve a "disposition." A "transaction" recorded on a blockchain activity ledger can represent a use of the digital asset or the data contained therein, and not necessarily a transfer denoting a "change of possession" as in a sale. As an example, where a self-actuating smart contract is used and activated in accordance with the contracting parties' instructions (or protocols), one or both parties are charged a usually-small fee in digital assets, most often units called "gas" on the Ethereum network which is the most widely-used network for smart contract operation. This means that the execution of a contract -- and really any use of a blockchain -- will trigger a transaction signifying the requisite network payment fee, which current tax law will recognize as a taxable event. However, on blockchains, such activity results in a transaction and the issuance of a "transaction ID." This compels the responsible taxpayer to keep and maintain additional documentation to demonstrate the absence of a disposition when he or she merely deploys the technology. 

At a minimum, the recordkeeping burden on obedient, responsible United States taxpayers is significant and is a disproportionate burden when compared to regular taxpayers. At a maximum, the use of the blockchain, by United States taxpayers and often in furtherance of United States innovation and economic development, will trigger "use taxes" (de facto sales taxes) that have no comparable equivalent with other competing information technologies. The use of blockchain technology can and will be strongly discouraged -- while America's and Americans' competitors face no such burdens. This threatens to become a huge competitive disadvantage compared to the rest of the world. 

Purchasers Of "Alternative" Protocols (Altcoins) Are Effectively Taxed When They Buy, Not When They Sell.  The classic Section 1031 imposes a tax on sales of property when subsequent exchanges are not made. The treatment of digital assets as personal property now makes digital assets taxable on their purchase because many alternative digital protocols ("altcoins") cannot readily be purchased anywhere with cash and can be obtained only by tendering a "major" digital coin (almost always bitcoin or ethereum) in exchange. Hence, a prospective "altcoin" buyer must make one purchase, but for tax purposes is treated as if he/she is making two transactions, of which the latter prong is now treated as a sale (and taxed as a short-term capital gain) instead of a tax-free exchange. Without Section 1031 like-kind exchange treatment, these type of transactions, where the economic reality is that of a purchase and not a sale, result in immediate capital gains tax liability -- a de facto sales tax, and worse, a sales tax at the short-term capital gains rate! As explained above, this is effectively a sales tax at a rate above 31% for most taxpayers, and for some taxpayers it could even exceed 40%. These are clearly punitive tax levels. Reinstating Section 1031 like-kind exchange treatment for digital assets would recognize the economic reality of what is really a unitary, two-step transaction in which they must first use cash or fiat currency to obtain a "gateway" digital asset (e.g., bitcoin), whose subsequent disposition in an exchange is necessary to complete the purchase of the token or digital asset which is the true object of the taxpayer/purchaser. 

ONE MORE ISSUE

While digital assets are taxable as property, digital assets have also encountered problems with valuation. This is critical to facilitate timely and accurate reporting of tax liabilities. Any tax bill should consider recognizing that the value of digital assets is difficult to measure, and that ascribing "value" for tax basis purposes using metrics more appropriate for financial instruments such as securities, commodities and so on is inappropriate because financial instruments are traded on developed, recognized markets; on the other hand, digital assets are often not tradable on United States markets or exchanges, the reported prices may not reflect the then-current market value, and there are questions regarding the best execution of orders on these exchanges which we believe distort reported prices and "bid" and "ask" offers, and realized prices. There are also reports of manipulation of asset prices on exchanges (which the Justice Department is currently reportedly investigating). There are liquidity issues with many exchanges handling digital assets. As such, the real value of digital assets should (we contend) be considered significantly lower than the reported price, and basis calculations should account for the inaccuracies and distortions in any trading arena for these assets.
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