ProShares Bitcoin ETF and Futures Taxation

 

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.

The Taxation of a Bitcoin

It wasn’t too long ago I was speaking with a friend who has a high-level position in the financial industry. The conversation included a reference to Bitcoins and how they might impact what he and his company do. We spent a moment on what Bitcoins are and how they are used.

I am still a bit confused. Bitcoins are a “virtual” currency. They are not issued or backed by any nation or government. They took off as a vehicle for wealthy Chinese to get money out of the mainland, and their market value over the last year has bordered on the stratospheric: from approximately $13 to over $1,000 and back down again. Understand: there is no company in which you can buy stock. To own Bitcoins, you have to own an actual “Bitcoin,” except that Bitcoins is a virtual currency. There is no crisp $20 bill in your wallet. You will have a virtual wallet, though, and your virtual currency will reside in that virtual wallet. I suppose some virtual pickpocket could steal your virtual wallet crammed with virtual currency.

You can own a gold miner stock, for example, although the decision to do that would have proved disastrous in 2013. Then there are Bitcoin “miners,” if you can believe it. Bitcoins presents near-unsolvable mathematical problems, and – if you answer them correctly – you might receive Bitcoins in return. That is how new Bitcoins are created. There a couple of caveats here, though: first, the problems are so complicated that you pretty much have to pool your computer with other people and their computers to even have a prayer of solving the problem. There is also a dark side: the computer security firm Malwarebytes discovered that there was malware that would conscript your computer and its processing power to aid others mine for Bitcoins. Second, only 21 million Bitcoins are supposedly going to be created. Call me a cynic, but look at our government’s fiscal death wish and tell me you believe that assertion.

Bitcoins are tailored made for illegal activities. The currency is virtual; there are no bank accounts or financial institutions to transfer information to the government - yet. China has banned their financial institutions from using Bitcoins, and Thailand has made it illegal altogether. Bitcoins was tied into Silk Road, which was an eBay (of sorts) for drugs and who knows what else. One apparently had to be a computer geniac to even get to it, as Silk Road resided in the dark web and required specialized access software (such as Tor) to access. Its founder was known as Dread Pirate Roberts (I admit, I like the pseudonym), and Silk Road accepted only Bitcoins as payment. The Pirate gave an interview to Forbes and was subsequently arrested by the FBI. You can draw your own conclusion on the cause and effect.

Did you know that there are merchants out there who will accept payment in Bitcoins, and in some cases only in Bitcoins? There is even a small town in Kentucky that agreed to pay its police chief in Bitcoins.

So how would Bitcoins be taxed? It depends. Let’s say you are trading the Bitcoins themselves, the same way you would trade stocks or baseball cards. You then need to know whether the IRS considers Bitcoins to be a currency or a capital asset.

There is a downside to treating Bitcoins as a currency: IRC Section 988 treats gains and losses from currency trading as ordinary gains and losses. This means that you run the tax rates, currently topping-out at 39.6% before including the effects of the PEP and Pease phase-outs and as well as the ObamaCare taxes.

What if Bitcoins are treated as a capital asset? We would then have company. Norway has decided that Bitcoins is not a currency and will charge capital gains taxes. Germany has said the same. Sweden wants to subject Bitcoins to their VAT. The advantage to being a capital asset is that the maximum U.S. capital gains tax is 20%. However, remember that capital losses are not tax-favored. Capital losses can offset capital gains without limit, but capital losses can offset only $3,000 of other income annually.

There is a capital asset subset known as commodities. Futures trades on a currency (as opposed to trading the actual currency itself) are taxed under Section 1256, which arbitrarily splits any gain into 60% long-term and 40% short-term. Now only 60% of your gain is subject to the favorable long-term capital gains tax. However, futures contracts on Bitcoins do not yet exist.

What if you are not trading Bitcoins but rather receiving them as payment for merchandise or services? This sounds like a barter transaction, and the IRS has long recognized barter transactions as taxable. What price do you use for Bitcoins? There are multiple exchanges – Mt. Gox or coinbase, for example – with different prices. One could take a sample of the prices and average, I suppose.

I also question what to do with the price swings. Say you received a Bitcoin when it was trading at $900. Under barter rules, you would have $900 in income. You spend the Bitcoin a week or month later when the Bitcoin is worth $700. You have lost $200 in value, have you not? Is there a tax consequence here?

If it were a capital asset, you would have “bought” it for $900 and “sold” it for $700. It appears you have a capital loss.

This doesn’t necessarily mean that that the loss is deductible. Your home, for example, is a capital asset. Gain from the sale of your home is taxable if it exceeds the exclusion, but loss from the sale of your home is never deductible.

If it were a currency AND the transaction was business-related, you would have a deduction, but in this case it would be a currency loss rather than a capital loss. A currency loss is an ordinary loss and would not be subject to the $3,000 annual capital loss restriction.

If it were a currency AND the transaction was NOT business-related, you are likely hosed. This would be the same as vacationing in Europe and losing money from converting into and out of Euros. The transaction is personal, and the tax Code disallows deductions for personal purposes.

What do you have if you “mined” one of those Bitcoins? When are you taxed: when you receive it or when you dispose of it?

Bitcoins are virtual currency. Do you have to include Bitcoins when you file your annual FBAR for financial accounts outside the U.S. with balances over $10,000? Where would a Bitcoin reside, exactly?

The IRS has not told us how handle the taxation of Bitcoins transactions. Until then, we are on our own.