Bitcoin surged in 2017, turning many early adopters of the cryptocurrency into millionaires. Wherever money's being made, you can count on the IRS to want its cut, and thanks to tax reform efforts, winners in the bitcoin world have now lost a key strategy they had hoped to use to diversify their holdings and avoid the tax man.
Tax reform efforts centered on broad-based changes to the individual and corporate tax system. Along the way, though, lawmakers also sought to clamp down on certain specific niches in which they saw potential for tax abuse. The cryptocurrency market is an obvious place for aggressive tax avoidance attempts from traders. By taking away the benefits from one key provision -- the like-kind exchange -- bitcoin profiteers won't be able to diversify their cryptocurrency holdings in a tax-free manner any longer.
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The basics of cryptocurrency taxation
When bitcoin first became popular, it wasn't clear how the IRS would tax it. The tax agency eventually settled on treating cryptocurrencies like capital assets, and that decision had both positive and negative implications for investors.
On one hand, treating bitcoin as a capital asset gave investors the chance to claim preferential long-term capital gains rates on sales of cryptocurrencies that they had held for longer than a year. Long-term rates of 0% to 20% are still much better than the 10% to 37% rates that apply in 2018 under tax reform laws.
However, treating bitcoin as a capital asset meant that every single time you used bitcoin in a transaction, you created a taxable event. Even spending bitcoin at a store would require you to report the value of the goods you received in exchange for the bitcoin, what you initially paid for that bitcoin, and the difference that would in turn represent taxable capital gains income or loss.
That created a conundrum for bitcoin investors: how to cash in on their profits without having to pay tax. Fortunately at the time, IRS treatment of bitcoin also opened the door to a strategy commonly used among real estate investors.
How like-kind exchanges work
Section 1031 of the Internal Revenue Code provides for tax-free treatment of transactions involving an exchange of assets that are of like kind. For instance, if you own an apartment building that you hold out for rent and you sell it for cash, then you'll pay capital gains tax on the difference between the proceeds and the tax basis of the property. However, if you exchange the building for a different apartment building, then no tax is immediately due, and any gain is deferred until you sell the second building.