This week something happened that made me think of a
friend who passed away last year.
I remember him laboring me on the benefits of CBD oil
and the need to invest in Bitcoin.
When he and I last left it (before COVID last year),
Bitcoin was around $10 grand. It is over $60 grand presently.
Missed the boat and the harbor on that one.
This past week ProShares came out with a Bitcoin ETF
(BITO). I read that it tripped the billion-dollar mark after two or three days
of trading.
With that level of market acceptance, I suspect we
will see a number of these in the near future.
This ETF does not hold Bitcoin itself (whatever that
means). It instead will hold futures in Bitcoin.
Let’s talk about the taxation of futures.
First, what are futures and what purpose do they serve?
Let’s say that you are The Hershey Company and you
want to lock-in prices for next year’s cacao and sugar. These commodities are a
significant part of your costs of production, and you want to have some control
over the price you will pay. You are a buyer of futures commodity contracts –
in cacao and sugar – locking in volume, price and date of delivery.
Whereas you do not own the cacao and sugar yet, if their
price goes up, you would have made a profit on the contract. The reverse is
true, of course, if the price goes down. Granted, the price swing on the futures
contract will likely be different than the swing in spot price for the
commodity, as there is the element of time in the contract.
That said, there is always someone looking to make a
profit. Problem: if commodity traders had to actually receive or deliver the commodity,
few people would do it. Solution: separate the contract from actual product
delivery. The contract can then be
bought and sold until the delivery date; the buyers and sellers just settle-up
any price swings between them upon sale.
It would be also nice to have a market that
coordinates these trades. There are several, including the Chicago Mercantile
Exchange. The Exchange allows the contracts to be standardized, which in turn
allows traders to buy and sell them without any intent to ever receive or
deliver the underlying commodity.
The ETF we are discussing (BITO) will not own any
Bitcoin itself. It will instead buy and sell futures contracts in Bitcoin.
Bitcoin futures are considered “Section 1256 contracts”
in tax law.
Section 1256 brings its own idiosyncrasies:
* There is a mark-to-market rule.
The term “mark” to an accountant means that something is reset to its market price. In the context of BITO, it means that – if you own it at year-end – it will be considered to have been sold. Mind you, it was not actually sold, but there will be a “let’s pretend” calculation of gain or loss as if it had been sold. Why would you care? You would care if the price went up and you had a taxable gain. You will soon be writing a very real check to the IRS for that “let’s pretend” mark.
* The 60/40 rule
This rule is nonintuitive. Whether you have capital gains or losses, those gains and losses are deemed to 60% long-term and 40% short term. The tax Code (with exceptions we will ignore for this discussion) does not care how long you actually owned the contracts. Whether one day or two years, the gain or loss will be deemed 60/40.
Mind you, this is not necessarily a bad result as long-term capital gains have favorable tax rates.
* Special carryback rule
If you have an overall Section 1256 loss for the year, you can carryback that loss to the preceding three years. There is a restriction, though: the carryback can only offset Section 1256 gains in those prior years.
This is a narrow rule, by the way. I do not remember ever seeing this carryback, and I have been in tax practice for over 35 years.
I do not know but I anticipate that BITO will be
sending out Schedules K-1 rather than 1099s to its investors, as these ETFs
tend to be structured as limited partnerships. That does not overly concern me,
but some accountants are wary as the K-1s can be trickier to handle and
sometimes present undesired state tax considerations.
Similar to my response to Bitcoin investing in early
2020, I will likely pass on this opportunity. There are unusual considerations
in futures trading – google “contango” and “backwardation” for example – that you
may want to look into when considering the investment.
