If You Held Bitcoins In 2017 Put Your Tax Return On Extension

The IRS concerns itself with virtual currencies that are used for “real world” transactions (Don’t worry so much about your World of Warcraft gold).  Coinmarketcap.com tracks 1,582 different cryptocurrencies.  As of yesterday (3/24/18) evening, they range in market capitalization from Bitcoins which are collectively worth over $151 billion to Dibcoins which are worth just over one thousand dollars (all five million of them).  Dibcoin is number 1271 on the list.

The balance apparently do not have a discernible market capitalization.  There are over one hundred currencies with market capitalization over $100 million. Bitcoin has a daily transaction volume over $6 billion.  There are nineteen currencies with daily transaction volume over $100 million.  So there is a lot going on there, a lot of it in just Bitcoin, but by no means all.

As I write this the five top currencies in market capitalization are Bitcoin, Etherium, Ripple, Bitcoin Cash and Litecoin. Meaning no disrespect to its 1,500 plus brother and sister currencies, I will pretty much assume you have been just fooling with Bitcoin.  As it happens at least for 2017, that also means you have to consider Bitcoin Cash.  Wait till we get to the fork to consider the latter.

What Is Virtual Currency?

I spent some time speaking with Perry Woodin who is the Chief Strategy Officer of HashChain Technology which recently acquired NODE40.  The conclusion I reached is that I am not going to try to explain how it is that Bitcoins and other virtual currencies based on the block chain work. So if you want to read about Satoshi Nakamoto, proof-of-work,  Byzantine generals and elliptic curves, you can hunt around elsewhere.  Here is the explanation on the Bitcoin site that tells us what we need to know:

From a user perspective, Bitcoin is nothing more than a mobile app or computer program that provides a personal Bitcoin wallet and allows a user to send and receive bitcoins with them. This is how Bitcoin works for most users.

Behind the scenes, the Bitcoin network is sharing a public ledger called the “block chain”. This ledger contains every transaction ever processed, allowing a user’s computer to verify the validity of each transaction. The authenticity of each transaction is protected by digital signatures corresponding to the sending addresses, allowing all users to have full control over sending bitcoins from their own Bitcoin addresses. In addition, anyone can process transactions using the computing power of specialized hardware and earn a reward in bitcoins for this service. This is often called “mining”.

Who’s Gonna Know?

You and I and everybody we know are all diligent in tax compliance.  We will report our Bitcoin transactions, because it is the right thing to do.  There are other people out there though that need a stronger incentive.  Here is the reason why using Bitcoins like they were untraceable cash is really, really dumb.  From that explanation above we have:

…. the Bitcoin network is sharing a public ledger called the “block chain”. This ledger contains every transaction ever processed, allowing a user’s computer to verify the validity of each transaction.

Every Bitcoin transaction ever is publicly available forever. It is true that you are anonymous.  Whoever owns wallet 13HazMQj3V3ew4BowCrVTp1yDvwAnyVYXL that transferred 10.5 bitcoins on March 24, 2018 probably thinks it is all private, but if any of the people on the other side of the transactions know that old 13HazMQ is actually my friend James and rat him out to the IRS, which is likely given some of the people James associates with, the IRS will be able to learn about all the 619 Bitcoins that came and went from that account.  At current values that is over $5 million.  Perry told me that the IRS is already working on it.

If you fail to report a large amount of gross income, the statute of limitations on your tax return is extended from three years to six.  If you don’t file at all the statute is forever. All your transactions on the block chain are also easily accessible forever. It is just a matter of connecting them to you.

The Rules

The IRS ruling referred to in the warning Notice 2014-21 really boils down to two things.  First, Bitcoins are not tax fairy dust.  If somebody pays you in Bitcoins instead of dollars or euros or whatever, you have exactly the same type of income as you would have had they been more conventional.  Second, Bitcoins (and all the other virtual currencies) are property.  That means that when they are exchanged for something else including money, you have to recognize gain and (possibly loss).  That’s a real pain if you have a lot of transactions.  It is particularly difficult if you used Bitcoins to buy things.  If you have been dealing in Bitcoins, though, you need to at least give it a shot.  And here is where the blockchain comes in handy.

You send the public identity of your accounts to Node40 or bitcoin.tax or libratax.com and they produce a capital gains schedule for you.  Perry says you should definitely use Node40.  They are better because they use specific identification.  He admitted that if I called up any of the other companies (there are more than the three I mentioned), they will have a story about why they are better.  My advice at this point is to shop around and do an assessment as to whether the report you get seems to make sense.  Here’s the thing.  If you go to this trouble and report something you will probably be in the top tier when it comes to compliance.  If your transaction volume is not very high, you should be able to do it yourself.

And Then There Is The Hard Fork

Bitcoin Cash resulted from a difference in opinion about how to run the block chain – something to do with scaling.  Maybe you can find a Byzantine general that can explain it to you. Here is the important thing.

Anyone who held Bitcoin at the time Bitcoin Cash was created became owners of Bitcoin Cash . This means that Bitcoin holders as of block 478558 (August 1st, 2017 about 13:16 UTC) have the same amount of Bitcoin Cash as they had Bitcoin at that time. If your Bitcoins are stored by a third party such as an exchange, then you must inquire with them about your Bitcoin Cash.

If you owned your Bitcoins through an exchange, you might have to jump through some hoops.  Perry Woodin has talked to quite a few Big 4/ Top 10 accountants is convinced that the receipt of Bitcoin Cash was a taxable transaction.  Most of the articles that I have  found written since August seem to support that view.  According to one in Dynamic Post, the income pickup would be 9.5% of the value of your Bitcoins at the fork which works out to $266 per Bitcoin Cash unit.  Jeff John Roberts in Fortune expresses a similar view as does fellow Forbes contributor Robert Green.

Are They Right About The Income Pickup?

Thanks to my sensible client base, I was blissfully unaware of the fork that created Bitcoin Cash until I spoke with Perry Woodin. If the IRS had actually issued any sort of ruling or pronouncement on the subject, that would not have been the case.  It has not.

An income pickup at the time of the fork based on the value then, giving you basis in your Bitcoin Cash equal to the income recognized and a holding period that starts on August 1 does seem like a reasonable answer.  I could come up with other answers though and you will find commentary on why those other answers are wrong.  But no authority.

I reached out to my brain trust on this one and struck gold with Professor Adam Chodorow

The IRS has asked for comments so that it can issue some guidance on hard forks. There is no authority that obviously applies, and a number of options exist. In large part, the answer depends upon what analogous activity best applies. For instance, if we look at the new coins received as interest on existing assets, hard forks should produce income at the moment of the fork. In contrast, if we think of it more like a stock split, it looks more like a change in the form of ownership and not the receipt of something new. My sense is that the former is more accurate than the latter as a description of what is happening, but the IRS can control the outcome by declaring that it will adopt one analogy or the other. Hard forks present a number of issues that make the interest analogy more difficult than might initially appear. It is sometimes not clear what the value of the new coins are at the moment of the split. It takes the market some time to set value. In addition, in some cases the taxpayer must take steps to claim the coins. What should happen if the taxpayer effectively disavows the coins by not claiming them? The stock split analogy is also difficult because the new coins are actually different from the original. It is not as if the taxpayer now has two ½ coins instead of one full coin. The taxpayer has the original coin and something new.

Practical considerations may be the most important element in determining what the rule should be. For instance, to avoid having to allocate basis from old to new coins or determine value at the time of the split, the best answer would be to declare that the hard fork is a realization and recognition event, but the value of the new coin is zero. That triggers a gain of $0 and sets the basis at $0. It also starts the clock on a holding period. If taxpayers start using hard forks in weird ways that make these rules unworkable, we can always revisit the rule. If I had to guess, the IRS will go with a rule like this, at least in the short run, until it gains more experience and sees how taxpayers respond to such a rule. That said, there is no obviously correct answer, and the IRS could surprise us all.

Karen Hawkins Chair of the ABA Tax Section wrote to the IRS Acting Commissioner on March 19, 2018 suggesting a safe harbor, which would be an income pickup of zero, with zero basis and a holding period starting on the date of the Hard Fork.  That seems like a reasonable answer, but again it is not authority.

How long will it take for the IRS to get around to issuing something?  Too long to react to the ruling by April 17, but we can hope there might be something by October 15 when extended returns are due.

What Should You Do?

If you want to be compliant and Bitcoin – Bitcoin Cash transactions are material to your return, filing an extension – Form 4868 – is really your best option.  If you can afford to, pay in an estimated  tax that is based on the worst case scenario as to how the IRS might rule.  Then forget about it and check back in August or September.  If there is still no word from the IRS, there will at least be a lot more commentary and you will probably be able to find a reasonably well supported option that you find most congenial.

If you have some sort of resistance to filing an extension, just get over it.