The new tax law’s elimination of miscellaneous itemized deductions has bitcoin investors asking whether they should re-categorize themselves as “traders” for tax purposes—but they may want to proceed with caution.
Under prior law, taxpayers could use the miscellaneous deduction to write off certain investment-related expenses if they exceeded 2 percent of their adjusted gross income.
Virtual currency investors were permitted to write off trading expenses—such as computer and internet, subscriptions to cryptocurrency-related sites, software subscriptions, specialized computer equipment—even if they weren’t trading bitcoin as an occupation, Jeff Vandrew Jr., an attorney and CPA at Vandrew LLC in New Jersey whose practice covers taxation of cryptocurrencies, told Bloomberg Tax in an email.
The 2017 tax law has taken that option away from investors in the explosive—although inconsistent—virtual currency market. The price of the largest and best-known digital currency, bitcoin, soared above $19,000 in mid-December, but plunged Jan. 16 after South Korea’s top financial policy maker said a crackdown on the trading of cryptocurrencies remains possible.
The impact of removing the miscellaneous deduction for bitcoin users is mitigated by the former deduction’s 2 percent floor and the fact that investors had to itemize in order to get it, Vandrew and Jason M. Tyra of Jason M. Tyra, CPA, PLLC, in Dallas, said. Because of that floor, “the volume of people that could have done it anyway is probably really low,” Tyra told Bloomberg Tax.
Even so, Tyra and Vandrew said they’ve had clients calling to ask if they should re-characterize themselves as traders—meaning that buying and selling bitcoin would qualify as their trade or business—to write off more of their expenses now that the deduction has been eliminated. Under this scenario, those expenses are fully deductible, not subject to a 2 percent requirement.
If transitioning to being a trader “is possible under the facts, it often is a good idea because you can deduct expenses,” said Bryan C. Skarlatos, a partner at Kostelanetz & Fink LLP. But the facts make all of the difference.
To be a trader, a person has to engage in regular, continuous, and substantial trading activity, he told Bloomberg Tax in an email. “The IRS will look at how long you hold the property, the frequency of trades, the amount of time you devote to the activity and how that compares to other businesses in which you engage,” Skarlatos said. The agency “often disagrees with taxpayers on whether they are traders and then penalties can be at issue unless it is a very close call.”
Tyra said “the vast majority of the time,” becoming a trader for tax purposes is “going to create a higher tax burden for people.” A person who’s job is to trade virtual currencies no longer has access to the long-term capital gains rate because now that person is engaged in a business activity, not an investment activity, he said. “They also would be required to pay self-employment taxes on their net gains at the end of the year.”
Perhaps such a move makes sense for a virtual currency hedge fund but not for the everyday, casual investor, he said.
Vandrew took a different view on the self-employment tax issue. “The only guidance on whether your trading qualifies as you as a ‘trader’ rather than an ‘investor’ is IRS Tax Topic 429, which doesn’t reference whether cryptocurrency traders can qualify as ‘traders,’” he said.
Tax Topic No. 429 says a securities trader isn’t subject to self-employment tax on the gains and losses that result from selling securities.
Cryptocurrencies don’t meet the definition of a security under the tax code, but “if someone can be a trader in non-security investment property, it would be illogical that self-employment tax would apply to him but not a securities trader,” Vandrew said.
“There is no statute regarding self-employment tax that would treat securities trading differently from any other investment property,” he said.
The IRS doesn’t specifically comment on this issue in Notice 2014-21—the agency’s only guidance on bitcoin tax issues. Practitioners and tax groups have requested more guidance from the IRS to provide clarity on some of these gray areas. The agency didn’t respond to a request for comment.
Bitcoin as a Security?
In Notice 2014-21, the IRS specified that virtual currencies are “property” for tax purposes.
Securities are also property, but Vandrew and Tyra both said it’s clear that cryptocurrencies don’t meet the definition of a security as defined by tax code Section 475(c)(2).
Under that section, all the items that qualify as a security have a counterparty, Tyra said. “Virtual currency doesn’t have that, nor is it secured by any legal relationship to someone or something else, nor does holding it create any rights or obligations on the part of the holder,” he said.
Not everyone agrees that the answer is so cut and dried. The American Bar Association tax section in a 2015 report asked the IRS to clarify whether virtual currencies are securities for purposes of Section 475(c)(2).
“There is a very plausible argument that under the right facts, Bitcoin or other virtual currency could be a security under Section 475 and thus subject to that provision,” said Elizabeth R. Carter, a professor of law at Louisiana State University who recently wrote a report on the taxation of virtual currency for Bloomberg Tax. “The IRS has not offered any guidance on that point.”
With assistance from Laura Davison in Washington.