This is a common question that I get from my tax clients. It is generally accompanied by other (and sometimes less realistic) questions and ideas like:
- “Should I create an LLC in Puerto Rico and transfer my assets there?”
- “Does forming a S-Corp allow me to deduct extra expenses?”
- “Would the IRS even know if I never reported my trading activity?”
I may write another article to answer some of these more aggressive tax-planning thoughts, but for now, I want to focus on the one that can (for a very brief time) still be used; Section 1031 of the Internal Revenue Code, also known as Like-Kind Exchange. This provision allows property owners to defer the gains realized from exchanging similar assets to a future time when said asset is sold for cash.
This provision originally intended to be used for real estate, but it became significant for crypto investors because the IRS considers crypto currency to be property, not currency. Therefore, tax payers have used Like-Kind Exchange to defer the gains that arise when they trade one crypto coin for another. I did this for dozens of clients in the years leading up to 2018, when the IRS finally ruled that Like-Kind Exchange cannot be used for crypto currency. This begs the question:
“Is there still a way to use the Like-Kind provision to defer your capital gains from crypto trading?“
The answer is “yes, but not for long.”
The IRS disallowed the use of Like-Kind Exchange for crypto currencies for tax year 2018 and beyond, but taxpayers can still take advantage of the provision if they amend their 2017 tax return to claim it. Why can’t tax years before 2017 be amended to claim Like-Kind? Because the IRS has a strict deadline for amending tax returns, which is three years following the date the original return was filed. Since most 2017 tax returns were filed in the Spring of 2018, taxpayers have until Spring of 2021 to amend that tax return. It’s too late for any returns before that.
“Does Like-Kind Exchange apply to me?”
If you were trading crypto currencies in 2017, and you paid taxes on short-term gains recognized from the trading of those coins, you can benefit from Section 1031. However, selling crypto for cash does not constitute a trade, and the gains from that transaction cannot be deferred. The most common clients of mine who benefit from this provision are those who were purchasing alt-coins using BTC. For example, someone might trade 0.05 BTC for 1,000 units of some alternate coin (probably Dogecoin if they’re a Redditor). That event, in the eyes of the IRS, counts as a sale of the BTC, and the taxpayer will have to report a gain if the BTC used in the purchase had increased in value from when they bought it. That gain can be deferred using Section 1031.
Now, I must be clear, deferring a gain is not the same as eliminating it. When you defer a gain using Like-Kind, you are simply moving that gain to a further date when you sell the coin that you acquired in the trade. That gain may be more or less than the original gain, depending on what has happened to the price of the crypto. The only amount that remains the same is the basis in the coin you originally sold. It is transferred to the new coin.
There’s one final thing that crypto traders should understand. Claiming Like-Kind Exchange is not a guarantee, and just like with any amended return, the IRS can reject it. I tell my clients who want to amend their 2017 return to claim Section 1031 that the IRS ultimately decides which amended returns they want to approve, and their list of reasons is long and invisible to us all. Furthermore, by amending a prior return, you open yourself up to the risk of being audited. I generally only file these types of amended returns for clients who paid a significant amount of money in taxes from their crypto trading, because the risk and the effort is worth the chance that the amendment is accepted.
You can still use Section 1031 to defer your crypto gains and claim a refund on the taxes you paid for those gains. But you must act fast. Spring of 2021 is fast-approaching, and with it, the deadline for amending 2017 returns.