Bitcoinist spoke with Alexander Stern, legal attorney and founder of Attorney IO, to unpack the complexities related to Bitcoin and cryptocurrencies taxes, potential loopholes for users, and how the IRS can easily track individuals using Bitcoin compared to fiat currencies.
The fact that a lot of this is on a blockchain (and cannot be tampered with) does make the IRS smile.
– Alexander Stern
Bitcoinist: First, how and for how long has your law firm been involved with Bitcoin and cryptocurrencies? Are you seeing increasing interest from clients?
Alexander Stern: I’m an attorney and the founder of Attorney IO. Attorney IO is a startup that provides legal AI to other lawyers to give them an AI’s perspective on the law. We proudly support lawyers working on the latest cryptocurrency issues, spanning from taxes to securities. I believe smart contract technology and legal AI are the future of the legal profession.
Bitcoinist: So do you see the legal profession also facing disruption? In other words, will many legal experts be replaced by AI and smart contracts in the future?
Alexander Stern: Yes, I think a huge number of lawyers will be replaced by AI and smart contracts. However, the best lawyers will embrace this techno-legal future rather than fight it. It is now common to get a joint degree in law and business.
With the rise of AI and smart contracts, I think we’ll start seeing a lot more people getting joint degrees in law and computer science.
Bitcoinist: Is trading crypto-to-crypto on an exchange like Binance or Poloniex, for example, a taxable event? Is it retroactive? If so, from what date did this go into effect?
Alexander Stern: We asked some of the top tax law professors in the country this question. The Attorney IO Panel Report generally found that starting January 1st, 2018, all crypto-to-crypto exchanges are taxable events.
This is the case whether you use an exchange such as Poloniex or even if you make a private swap without using an exchange. The only exception I’m aware of may be to use non-taxable retirement accounts. However, the panel said that, prior to 2018, a great deal of crypto-to-crypto exchanges are taxable events and have been since before the Bitcoin whitepaper was published. The question is whether the two crypto assets being exchanged are highly similar to each other in how they function.
For example, it is arguable that Bitcoin and Litecoin are sufficiently similar to suggest swapping one for the other may be a non-taxable “like-kind exchange.”
On the other hand, one panelist said, “I don’t think a swap of cloud storage for a car is LK [like-kind]. So why should a digital asset that allowed you only to get cloud storage be LK [like-kind] with a digital asset that could be redeemed only for a car?” In other words, all exchanges going back to Bitcoin’s release are potentially taxable events, especially when the two coins are meaningfully different in function.
Bitcoinist: Is it possible to have taxable gains despite never having been converted into dollars? Moreover, what if the gains were wiped out by later unrealized losses?
Alexander Stern: Yes, this is the single biggest news of the panel report. The blockchain ecosystem could move into a second generation of coins and leave the first generation in the dust. If that happens and most of this first wave of tokens drop to levels seen only a few years ago, thousands of families could owe tens of billions of dollars in taxes, despite receiving much less than that in dollars. This could haunt people for the rest of their lives.
One panelist, Prof. Ainsworth, answered this question as follows: “Absolutely. The same happens in any real estate bubble where people are flipping homes. Some people flip every month, and if they end up flipping a $1 million home at the top of the market, and the value of all real estate ‘tanks,’ it is possible to have [taxable] gains that exceed the current market value of real estate.”
Another panelist, Prof. Kane, said, “I could exchange an appreciated, valuable painting for a farm. Not like kind (even before 2017 changes), so I recognize gain. But then the land market crashes, and I take a big loss. Was it wrong for the system to tax me given I did not really end up with any gain at the end of the day?”
Alexander Stern: Cryptocurrencies are a completely new technology and paradigm. Regulators could decide they have features of both securities and commodities. It will also likely depend on the token itself rather than the asset class as a whole.
Bitcoin looks a lot more like a commodity. The latest ICO often looks a lot more like a security.
Ultimately, one token could be regulated as both a security and a commodity. This could mean at least two federal agencies would have simultaneous authority over one token.
Bitcoinist: Many people in the crypto space get paid salaries in Bitcoin, for example. Would this be taxable the same as income in dollars?
Alexander Stern: Yes. If you get paid in Bitcoin or any other digital asset, you generally have the same tax responsibilities as payment in dollars.
Bitcoinist: We’ve seen instances where people claim they got “hacked” and that the funds are no longer theirs. How can the IRS technically prove that an individual has control of their funds?
Alexander Stern: In my opinion, this seems very similar to losses due to theft outside of the blockchain. If you keep half of your salary as cash under your mattress, it is vulnerable to theft too. In some cases, the IRS does allow you to deduct for theft, but it is a very case-specific process. If you have a substantial theft from a cryptocurrency hack, you should get a tax attorney to guide you.
Documentation, such as police reports or news articles on a major hack, can be crucial to demonstrate to the IRS that you did indeed lose money due to theft. Nobody should consider claiming a hack that is not genuine. That may lead to serious consequences that could include jail and fines.
Bitcoinist: Are there any legal loopholes that Bitcoin users can use to avoid taxation? For example, sending bitcoin to another person as a “gift”?
Alexander Stern: Generally speaking, no. A good rule of thumb in the tax world is to ask whether something would be effective if you use dollars instead of cryptocurrencies. If you get a salary in dollars or cryptocurrencies, you cannot avoid income tax by saying you gifted it all away.
Bitcoinist: The IRS is increasingly forcing third-party intermediaries to turn over records such as we’ve seen with Coinbase. However, since technological innovation is always one step ahead, could new tech, such as anonymizing features, decentralized exchanges, cross-chain atomic swaps, etc., make it even harder for authorities to track individuals? Who do you see winning this game of cat-and-mouse?
Alexander Stern: These new technologies could make it harder for the IRS but certainly not impossible. The Bitcoin blockchain is particularly susceptible to scrutiny. Panelist Prof. Ainsworth notes that “all the IRS needs to do is get a good computer out and draft assessment notices once they have the account numbers.
The fact that a lot of this is on a blockchain (and cannot be tampered with) does make the IRS smile. Assessments could not be easier. The metaphor of ‘fish in a barrel’ comes to mind.”
However, the IRS is a very capable agency. People try to dodge taxes outside of blockchain investments all of the time. When you start driving around in a Lamborghini but report only a small income, that raises some serious red flags. If the IRS can catch tax evaders using cash, it can do so with even the most sophisticated anonymous blockchain assets.
Bitcoinist: Given that 2017 was a record year in terms of price gains across the board for cryptocurrencies, do you believe we’ll see more people file taxes on the crypto returns this year or less?
Alexander Stern: All sorts of federal and state government agencies have seen the dramatic price appreciation of cryptocurrencies. They all want to increase their authority and get a piece of the pie. The panel report notes that only a few months ago we saw a ramp up in IRS scrutiny of Coinbase.
I think we’ll start seeing significant legal action taken against cryptocurrency tax dodgers, and this enforcement will spark a community-wide increase in paying taxes.
Bitcoinist: Do you think tax service companies like Turbo Tax or H&R Block will start offering cryptocurrency tax services as it becomes more popular?
Alexander Stern: Yes, I think that’s a great idea. Turbo Tax and H&R Block could make a ton of money by tapping into this burgeoning market. Most people want to comply with the law and that means paying taxes. These companies can make a few small additions to their systems and capture this market.
Bitcoinist: What’s your advice for cryptocurrency users moving forward? Should they keep track of every single transaction and trade?
Alexander Stern: The panel report does find people should track every single trade. Panelist Prof. Chodorow says, “To comply with the tax laws, keep track of how much you paid for each coin. Further, keep track of which coin you sell or spend as well as the value of the coin at the time you dispose of it. You will also need to determine how long you have held the coin. If you hold your coins at one of the exchange companies, those companies should be able to provide you that information.”
He adds, “Any time that you sell or spend a virtual coin, you will have a tax gain or loss if the value of the coin at the time you sold or spent it differs from the value when you acquired it.”
In other words, even if you buy a small item such as a cup of coffee, you are technically incurring a tax obligation.
It is no different than if you sold $5 in Bitcoin and took that $5 to the coffee shop. Both events are taxable. While this could limit the practical use of these assets as currencies, it may not be so onerous if you are with an exchange that automatically records all of the necessary information each time you make a trade.
Bitcoinist: Finally, where can people find more information on this topic?
Alexander Stern: I suggest that people read the entire Attorney IO panel report on cryptocurrency taxes and adjust their bookkeeping and tax strategies accordingly. Some of the best law professors in the world took the time to educate the cryptocurrency community about their obligations. It’s worth looking into what they have to say.
Did you pay your cryptocurrency taxes this year? Share your comments below!
Images courtesy of Shutterstock, Attorney IO