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The Empire Strikes Back: How to Be a Crypto-Jedi

July 27, 2019
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The Empire Strikes Back: How to Be a Crypto-Jedi

Friday’s reports that the IRS is sending thousands of warning letters to American cryptocurrency holders is far from a war on bitcoin.


It is, however, an effort to use the implicit (or explicit) agency enforcement and prosecutorial powers to deter misreporting. This is unusual, given that crypto holdings are not that prevalent in the United States. So what else could it mean?


The federal tax code has long been a tool to determine favored and disfavored activities, the country’s winners and losers. So who gets hurt by increased IRS scrutiny? 







First, remember that federal tax liability comes only from transactions, not from holding bitcoin and other crypto. Owning bitcoin is not what’s being targeted. Rather, it’s the inconvenience of recordkeeping of all “taxable events” which is the easiest hammer to lift. 


But if you aren’t trading crypto and holding it — in other words, you see crypto as a store of value — then you are not having the transactions which trigger tax liability (or reportable, claimable losses to offset gains). Without transactions as a trigger for taxation, the IRS won’t be involved. Therefore, if the IRS is “targeting” crypto activity, it’s crypto’s use in commerce as a means of exchange, an alternate non-fiat money substitute, which is in the crosshairs. 


However, many altcoins can only be bought and sold by engaging in two transactions, one from fiat to crypto (usually bitcoin) and then the second from crypto to crypto. These transactions are already severely discouraged and punished under the current tax code because there is no like kind tax treatment after the Trump Administration’s December 2017 tax bill revised Section 1031 of the tax code. Currently, a purchase from fiat to altcoin often means that the second prong (e.g., bitcoin to altcoin) of the purchase involves a taxable event (which effectively is a sales tax on the purchase of the desired altcoin); meanwhile, selling an altcoin and getting cash requires a two step process whereby each step involves a separate taxable event.


An IRS enforcement campaign would not necessarily make tax treatment more unfavorable than it already is; it could discourage transactions and in particular, trading activity that occurs within the United States. The effects could be interesting, and not necessarily harmful. Speculation and wild trading would be discouraged – and certainly the use of crypto in all but the most important transactions – but HODLers might be rewarded with a more price-stable asset class that would in turn enjoy an enhanced perception of stability as a means of exchange and as a store of value.  Interest by crypto users (either for tech development or commerce) might be encouraged, not discouraged.


In the short run, crypto holders with taxable events may face increased inconvenience. This will be felt until the industry catches up with the seamless reporting that American investors have come to expect from legacy financial institutions which report interest, capital gains and dividends. However, reports of a government crackdown or charges of unfairness don’t seem warranted. Unlike much of the rest of the world which needs bitcoin as a stable means of exchange within economic ecosystems dominated by corruption and rampant inflation, the American crypto audience sees the asset class as a store of value. The relative luxury Americans enjoy will insulate them from the tax-driven headaches, which I predict will be confined to the trading community.