Wash Sale Proposal May Muddy Crypto Tax Compliance

Wash Sale Proposal May Muddy Crypto Tax Compliance

A proposal by Democrats to disallow tax losses from selling cryptocurrency if a substantially similar asset is repurchased within 30 days could add another layer of complexity to already-difficult digital currency tax compliance.

The House Ways and Means Committee's approval of a multitrillion-dollar tax portion of the Build Back Better Act in mid-September would amend the wash sale rule under Section 1091 of the Internal Revenue Code to include cryptocurrency.

Under the current version of the wash sale rule, if a "specified asset" is sold at a loss and something "substantially similar" is repurchased within 30 days, then that loss cannot be used for tax purposes. Therefore, any specified assets subject to the wash sale rule must be held for at least 31 days if an investor wants to utilize their tax losses against other taxable gains.

If passed, the statutory language of the Build Back Better Act would expand specified assets that fall under the rule to include "any digital representation of value that's recorded on a cryptographically secured distributed ledger or similar technology."

Nicholas R. Rosado of Rosado Tax Law said he's had clients who didn't know about the wash sale rule when they first started day-trading stocks on a massive scale and were later surprised by big tax bills, with the rule preventing them from using some of their tax losses against taxable gains.

If this problem of not knowing about the application of the rule, which has been around for some time, already exists in stock trading, then the same issue could come up for those trading cryptocurrency, Rosado said.

"So as it applies in that realm with securities, it's certainly going to apply here, and I think it's going to be a lot more difficult to comply," he said.

In 2014, the Internal Revenue Service issued Notice 2014-21, which requires cryptocurrency holders to treat virtual currency as property with a basis that must be subtracted from its value at the time of disposition in order to calculate a reportable gain or loss. And in 2019, the IRS reiterated its position that cryptocurrency is treated as property but did not specify what tax forms a cryptocurrency wallet or exchange must give to users.

Jonathan Sambur, a partner at Eversheds Sutherland, said the best way cryptocurrency holders can make sure they follow the wash sale rule is to keep good records for the currency that's bought and sold. By doing so, they would be able to track if they held something for shorter or longer than 30 days, he said.

"They're going to have to keep very meticulous records on purchases and sales because I think that, at least from my understanding, the data that is being provided by exchanges and persons that host wallets is inconsistent, and if it's done abroad, it's probably nonexistent," he said.

However, part of what can complicate tax reporting is when someone has to use the popular Bitcoin or Ethereum to do transactions with a lesser-known type of virtual currency, Sambur said. For example, if someone wants to convert a more obscure cryptocurrency into dollars or another fiat, they might have to convert it into Bitcoin or Ethereum first, he said.

"So if you're going in and out … you're likely to be generating losses or gains with respect to Bitcoin or Ethereum on a fairly regular basis," Sambur said.

That could put a cryptocurrency holder in an unknowing situation where the wash sale rule would apply since one could be generating losses with Bitcoin or Ethereum in less than 30 days, he said.

Different cryptocurrency wallets and exchanges also provide their customers with different types of tax forms, and that lack of uniformity may affect someone's ability to accurately report their holdings.

Under IRC Section 6045, brokers must file information returns on Form 1099-B for gross proceeds from the sale or disposition of covered securities, which include commodities. However, it is unclear whether a cryptocurrency is considered a commodity that would require a cryptocurrency broker to issue Form 1099-B.

Robinhood, a broker-dealer registered with the Financial Industry Regulatory Authority and U.S. Securities and Exchange Commission that also offers cryptocurrency trading, provides users who bought or sold cryptocurrency of more than $10 in 2020 with a consolidated Form 1099.

Meanwhile, virtual currency exchange Coinbase Inc. used to provide 1099-K forms to its U.S.-based customers with more than $20,000 in gross proceeds in 2019. Form 1099-K, which is connected to IRC Section 6050W, generally includes payment card transactions or settlement of third-party payment network transactions and simply provides someone's gross proceeds of sale and not the aggregate basis amounts in cryptocurrency sales or exchanges.

However, for tax year 2020, Coinbase said it will instead provide Form 1099-MISC to customers who meet certain criteria. That form is linked to compliance with IRC Section 6041, which requires reporting miscellaneous payments of more than $600 made in the course of a trade or business to a nonemployee for specified purposes like gains and profits.

So even if a cryptocurrency holder wants to comply with the wash sale rule, it will be harder to report tax amounts properly because cryptocurrency brokerages may not provide forms that would help holders track the basis amounts the same way stock brokerage firms do, Rosado said.

That's "because when you sell securities with any brokerage they're going to account for any disallowed wash sales," he said. So if a cryptocurrency broker does not provide this information to a holder, it will be hard for someone to know what their tax liabilities are, Rosado said.

Under IRC Section 1091 and related Treasury regulations, a wash sale happens when an investor sells a stock at a loss and purchases a substantially similar stock or security within 30 days after or before the sale. Since it's unknown what "substantially similar" may mean in the cryptocurrency industry, the safest approach if the law is passed may be to wait for guidance from the IRS on that point, Rosado said.

When it comes to stocks, shares in different companies aren't viewed as substantially similar, he said. So if someone buys Microsoft, sells it at a loss, then buys Facebook or Google, the wash sale rule won't apply, he said.

"So [the IRS] hasn't treated it that way in the securities realm, so you wouldn't think they'd be able to treat Bitcoin and Ethereum as the same asset [because] it's not the same asset," Rosado said. "It's going to depend on the interpretation, but even if they do interpret it that way, that's not the final word [because] the courts will have to decide whether that's the case."

Johnny Luna, an associate at the Gordon Law Group Ltd., said applying the wash sale rule gets even more complicated when a cryptocurrency holder owns virtual currency in more than one wallet or is involved in more complex deals such as margin trading or liquidity pools. In a liquidity pool, someone deposits money, so there's liquidity that can be traded in other parts of the world, which takes a lot more understanding of blockchain, he said.

"If you put [cryptocurrency] into a liquidity pool, sometimes you don't understand if it's a taxable event," Luna said.

Some cryptocurrency holders export a spreadsheet called a comma-separated values file, or CSV, but many people don't, so someone would have to create manual entries and try to understand whether a taxable event occurred and whether the wash sale rule applies, he said.

"We have clients, on average, who get involved in this margin trading and liquidity pools and [decentralized finance]; it gets more complicated … [but] that also depends on the amount of transactions," Luna said. "So, if there are persons having bots and many trades per day, it will take a longer period of time to look at date sold, because they're moving it from place to place … it would be really hard to track how the wash sale rule would apply to crypto."

What's more, cryptocurrency by its nature is worldwide and prices fluctuate 24/7, which differs from the likes of the New York Stock Exchange that have specific hours for stock trading, Luna said. So if a cryptocurrency price dropped suddenly and unexpectedly, a holder may want to dispose of the asset and may not think about the wash sale rule due to the rapid fall in price, he said.

"Most people specifically don't know how to record it," Luna said. "And from a technical perspective, it's going to be a nightmare for people who don't understand how to [track] this, and software is still trying to get up to date."

For now, it's too early to know whether people will trade cryptocurrency less if the wash sale rule does end up applying to the applicable transactions, he said.

"We'll have to wait and see," he said. "But as a general principle, we think it's going to hurt more in the crypto community if this rule is being applied just because of swings in the market."

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Wash Sale Proposal May Muddy Crypto Tax Compliancehttps://www.cbiz.com/Portals/0/Images/Hero-Article-WashSaleProposal.jpg?ver=34IXIp3tVhs7RfYZR1c77A%3d%3dA proposal by Democrats to disallow tax losses from selling cryptocurrency if a substantially similar asset is repurchased within 30 days could add another layer of complexity to already-difficult digital currency tax compliance.2021-10-19T17:00:00-05:00

A proposal by Democrats to disallow tax losses from selling cryptocurrency if a substantially similar asset is repurchased within 30 days could add another layer of complexity to already-difficult digital currency tax compliance.

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