The IRS has a tax code that allows like for like property exchanges to be tax-free. But what about cryptocurrencies like bitcoin and ethereum? Is exchanging one for another a taxable event? What is cryptocurrency to the IRS?
Cryptocurrency Swaps are Taxable says IRS
According to section 1031 of the IRS tax code, a taxpayer may “May defer recognition of capital gains and related Federal income tax liability on the exchange of certain types of property.” This code means essentially that in some cases, exchanging one kind of property for another can be a non-taxed event.
Instead, one must only pay taxes when they realize or cash out, their gains.
Historically, trading a piece of empty land for a storefront has been acceptable, but trading silver for gold has not. Even the IRS has been unwilling to issue a clear answer regarding cryptocurrency. Given that a gold to silver swap is unacceptable, however, it would appear unlikely that an exchange of bitcoin for litecoin would qualify under section 1031 rules.
Under the tax code, as it stands, cryptocurrency swaps will almost certainly be regarded as sales, and be taxed as such.
Qualified Third Party
Another point to consider if you are looking into 1031 swaps to avoid paying unnecessary taxes, is that the code requires a qualified third party to act as an intermediary. Traditionally, 1031 swaps referred to exchanging more traditional forms of property.
With cryptocurrency, what passes for a qualified third party is still not clear. Would an automated website or DAO that keeps careful records be acceptable, or does it need to be a person with a specific qualification? At this point, no one knows.
The IRS, at present, considers cryptocurrency as a form of property, and not a form of currency. As property, cryptocurrency is treated differently in the tax code, but the IRS has staunchly stated that profits made in cryptocurrency are entirely taxable.
Back in March of 2014, the IRS released publication IR-2014-36, which states that cryptocurrency is property, and all property transactions rules apply to its use.
For instance, if someone does is paid for a job in cryptocurrency, they would need to report that as income on their 1040 tax return.
Push for Real-estate Only 1031 Swaps
The House and the Senate are both currently pushing tax bills that call for the restriction of 1031 swaps to only apply to real estate, and not other forms of property. If the changes pass and eventually become part of the tax code, then 1031 and cryptocurrency will not likely be mentioned in the same sentence again.