Donating Cryptocurrency

 

I was reading something recently, and it reminded me how muddled our tax Code is.

Let’s talk about cryptocurrency. I know that there is bad odor to this topic after Sam Bankman-Fried and FTX, but cryptocurrencies and their exchanges are likely a permanent fixture in the financial landscape.

I admit that I think of cryptos – at least the main ones such as Bitcoin, Ethereum or Binance Coin – as akin to publicly traded stock. You go to www.finance.yahoo.com , enter the ticker symbol and see Bitcoin’s trading price. If you want to buy Bitcoin, you will need around $23 grand as I write this.

Sounds a lot like buying stock to me.   

The IRS reinforced that perspective in 2014 when it explained that virtual currency is to be treated as property for federal income tax purposes. The key here is that crypto is NOT considered a currency. If you buy something at Lululemon, you do not have gain or loss from the transaction. Both parties are transacting in American dollars, and there is no gain or loss from exchanging the same currency.

COMMENT: Mind you, this is different from a business transaction involving different currencies. Say that my business buys from a Norwegian supplier, and the terms require payment in krone within 20 days. Next say that the dollar appreciates against the krone (meaning that it takes fewer dollars to purchase the same amount of krone). I bought something costing XX dollars. Had I paid for it then and there, the conversation is done. But I did not. I am paying 20 days later, and I pay XX minus Y dollars. That “Y” is a currency gain, and it is taxable.

So, what happens if crypto is considered property rather than currency?

It would be like selling Proctor and Gamble stock (or a piece of P&G stock) when I pay my Norwegian supplier. I would have gain or loss. The tax Code is not concerned with the use of cash from the sale.

Let’s substitute Bitcoin for P&G. You have a Bitcoin-denominated wallet. On your way to work you pick-up and pay for dry cleaning, a cup of coffee and donuts for the office. What have you done? You just racked up more taxable trades before 9 a.m. than most people will all day, that is what you have done.

Got it. We can analogize using crypto to trading stock.

Let’s set up a tax trap involving crypto.

I donate Bitcoin.

The tax Code requires a qualified appraisal when donating property worth over $5,000.

I go to www.marketwatch.com.

I enter BTC-USD.

I see that it closed at $22,987 on January 27, 2023. I print out the screen shot and attach it to my tax return as substantiation for my donation.

Where is the trap?

The IRS has previously said crypto is property, not cash.

A donation of property worth over $5 grand generally requires an appraisal. Not all property, though. Publicly-traded securities do not require an appraisal.

So is Bitcoin a publicly-traded security?

Let’s see. It trades. There is an organized market. We can look up daily prices and volumes.

Sounds publicly-traded.

Let’s look at Section 165(g)(2), however:

    (2)  Security defined.

For purposes of this subsection, the term "security" means-

(A)  a share of stock in a corporation;

(B)  a right to subscribe for, or to receive, a share of stock in a corporation; or

(C)  a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.

The IRS Office of Chief Counsel looked at this and concluded that it could not see crypto fitting the above categories.

Crypto could therefore not be considered a security.

As property not a security, any donation over $5 grand would require a qualified appraisal.

There was no qualified appraisal in our example. All I did was take a screen shot and include it with the return.

That means no charitable deduction.

I have not done a historical dive on Section 165(g)(2), but I know top-of-mind that it has been in the Code since at least 1986.

Do you know what did not exist in 1986?

The obvious.

Time to update the law, me thinks.

This time we were discussing CCA 202302012.

Taxing Foreign Investment In U.S. Real Estate

One of the Ps buzzed me about a dividend item on a year-end brokers’ statement.

P:      “What is a Section 897 gain?”

CTG: It has to do with the sale of real estate. It is extremely unlikely to affect any of our clients.

P:      Why haven’t I ever seen this before?

CTG: Because this is new tax reporting.

We are talking about something called the Foreign Investment in Real Property Tax Act, abbreviated FIRPTA and pronounced FERP-TUH. This thing has been around for decades, and it has nothing to do with most of us. The reporting, however, is new. To power it, you need a nonresident alien – that is, someone who is not a U.S. citizen or resident alien (think green card) – and who owns U.S. real estate. FIRPTA rears its head when that person sells said real estate.

This is specialized stuff.

We had several nonresident alien clients until we decided to exit that area of practice. The rules have reached the point of absurdity – even for a tax practitioner – and the penalties can be brutal. There is an encroaching, if unspoken, presumption in tax law that international assets or activities mean that one is gaming the system. Miss something – a form, a schedule, an extension, an election - and face a $10,000 penalty. The IRS sends this penalty notice automatically; they do not even pretend to have an employee review anything before mailing. The practitioner is the first live person in the chain, He/she now must persuade the IRS of reasonable cause for whatever happened, and that a penalty is not appropriate. The IRS looks at the file - for the first time, mind you - says “No” and demands $10,000.

And that is how a practitioner gets barreled into a time-destroying gyre of appealing the penalty, getting rejected, requesting reconsideration, getting rejected again and likely winding up in Tax Court. Combine that with the bureaucratic rigor mortis of IRSCOVID202020212022, and one can understand withdrawing from that line of work.

Back to Section 897.

The IRS wants its vig at the closing table. The general withholding is 15% of selling price, although there is a way to reduce it to 10% (or even to zero, in special circumstances). You do not want to blow this off, unless you want to assume substitute liability for sending money to the IRS.

The 15% is a deposit. The IRS is hopeful that whoever sold the real estate will file a nonresident U.S. income tax return, report the sale and settle up on taxes. If not, well the IRS keeps the deposit.

You may wonder how this wound up on a year-end brokers’ tax statement. If someone sells real estate, the matter is confined to the seller, buyer and title company, right? Not quite. The real estate might be in a mutual fund, or more likely a REIT. While you are a U.S. citizen, the mutual fund or REIT does not know whether its shareholders are U.S. citizens or resident aliens. It therefore reports tax information using the widest possible net, just in case.

When Is Divorce A Tax-Deductible Theft?

 

I am reading a case involving tax consequences from a divorce.

More specifically, the (ex) wife trying to deduct $2.5 million as a theft loss.

That is a little different.

He and she got married in 1987. Husband (Bruno) lifted a successful career in the financial sector, and by 2005 was earning over $2 million annually.

There was an affair.

There was a divorce.

The Court ordered an equitable distribution of marital properties.

That did not seem to impress Bruno, who transferred no marital properties. The court held him in contempt, ordered him to pay interest and yada yada yada.

QUESTION: Can’t a court place someone in jail for contempt?

It appeared that the Court had enough of Bruno, and in 2010 the Court transferred real estate to the (ex) wife, with instructions to sell, keep the first $300 grand and transfer the balance to an escrow account. The property sold for $1.9 million. Th (ex) wife kept all the money, placing nothing in escrow.

Yep, the Court held her in contempt.

By now I am thinking that the contempt of this court is clearly meaningless.

In 2015 our esteemed Bruno filed for bankruptcy. He claimed he was down to his last $2,500.

Which raised the question of where all the money went.

In 2016 the (ex) wife filed suit against Bruno’s new wife and several companies that he, she or both owned.

Methinks we found where the monies went.

She filed a claim against the bankruptcy estate for $3.5 million.

Apparently, there was something to the (ex) wife’s claim, as the bankruptcy trustee filed suit against the new wife, against Bruno’s mother, the Bruno companies previously mentioned and some poor guy Bruno talked to while walking his dog around the neighborhood.

That case was settled in 2019.

Let’s be honest: there is really no likeable character in this story.

The (ex) wife amended her 2015 tax return to report a $2.5 million theft.

That – not surprisingly – created a net operating loss that went springing across tax years like kids at a pre-COVID McDonald’s Playland.

The IRS caught the amended return and said: No way. No theft. No loss. Get outta here.

And that is how we got to the Tax Court.

Establishing the existence of a deductible theft can be tricky in tax law. Yes, one always has the question of what was stolen, how much was it worth and all that. Tax law introduces an additional requirement:

·      One must establish the year in which the loss was sustained.

The blade is in Reg 1.165-1(d):

However, if in the year of discovery there exists a claim for reimbursement to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained  .. until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.”

It is not the “what” that will trip you up; it is the “when.”

There of course some Court guidance over the years, such as:

·      The evaluation should not be made “through the eyes of the ‘incorrigible’ optimist,” or

·      … the “mere possibility or the bare hope of a future development permitting recovery does not bar the deduction of a loss clearly sustained.”

Yep. That is like telling a baseball player to step to the plate against Jacob deGrom and “just swing the bat.”

Thanks for the advice there, pal.

And the Court decided against the (ex) wife.

No one believed Bruno when he filed bankruptcy in 2015 and claimed he was worth only $2,500. The trustee filed suit; the (ex) wife filed suit. Lawsuits were everywhere.

The Court stated that the (ex) wife may well have a theft loss. What she did not have was a theft loss in 2015.

Our case this time for the home gamers was Bruno v Commissioner, T.C. Memo 2020-156.

Don’t Be A Jerk

 

I am looking at a case containing one of my favorite slams so far this year.

Granted, it is 2020 COVID, so the bar is lower than usual.

The case caught my attention as it begins with the following:

The Johnsons brought this suit seeking refunds of $373,316, $192,299, and $114,500 ….”

Why, yes, I would want a refund too.

What is steering this boat?

… the IRS determined that the Johnsons were liable for claimed Schedule E losses related to real estate and to Dr. Johnson’s business investments.”

Got it. The first side of Schedule E is for rental real estate, so I gather the doctor is landlording. The second side reports Schedules K-1 from passthroughs, so the doctor must be invested in a business or two.

There is a certain predictability that comes from reviewing tax cases over the years. We have rental real estate and a doctor.

COMMENT: Me guesses that we have a case involving real estate professional status. Why? Because you can claim losses without the passive activity restrictions if you are a real estate pro.

It is almost impossible to win a real estate professional case if you have a full-time gig outside of real estate.  Why? Because the test involves a couple of hurdles:

·      You have to spend at least 750 hours during the year in real estate activities, and

·      Those hours have to be more than ½ of hours in all activities.

One might make that first one, but one is almost certain to fail the second test if one has a full-time non-real-estate gig. Here we have a doctor, so I am thinking ….

Wait. It is Mrs. Johnson who is claiming real estate professional status.

That might work. Her status would impute to him, being married and all.

What real estate do they own?

They have properties near Big Bear, California.

These were not rented out. Scratch those.

There was another one near Big Bear, but they used a property management company to help manage it. One year they used the property personally.

Problem: how much is there to do if you hired a property management company? You are unlikely to rack-up a lot of hours, assuming that you are even actively involved to begin with.

Then there were properties near Las Vegas, but those also had management companies. For some reason these properties had minimal paperwork trails.

Toss up these softballs and the IRS will likely grind you into the dirt. They will scrutinize your time logs for any and every. Guess what, they found some discrepancies. For example, Mrs. Johnson had counted over 80 hours studying for the real estate exam.

Can’t do that. Those hours might be real-estate related, but the they are not considered operational hours - getting your hands dirty in the garage, so to speak. That hurt. Toss out 80-something hours and …. well, let’s just say she failed the 750-hour test.

No real estate professional status for her.

So much for those losses.

Let’s flip to the second side of the Schedule E, the one where the doctor reported Schedules K-1.

There can be all kinds of tax issues on the second side. The IRS will probably want to see the K-1s. The IRS might next inquire whether you are actually working in the business or just an investor – the distinction means something if there are losses. If there are losses, the IRS might also want to review whether you have enough money tied-up – that is, “basis” - to claim the loss. If you have had losses over several years, they may want to see a calculation whether any of that “basis” remains to absorb the current year loss.

 Let’s start easy, OK? Let’s see the K-1s.

The Johnson’s pointed to a 1000-plus page Freedom of Information request.

Here is the Court:

The Johnsons never provide specific citations to any information within this voluminous exhibit and instead invite the court to peruse it in its entirety to substantiate their arguments.”

Whoa there, guys! Just provide the K-1s. We are not here to make enemies.

Here is the Court:

It behooves litigants, particularly in a case with a record of this magnitude, to resist the temptation to treat judges as if they were pigs sniffing for truffles.”

That was a top-of-the-ropes body slam and one of the best lines of 2020.

The Johnsons lost across the board.

Is there a moral to this story?

Yes. Don’t be a jerk.

Our case this time was Johnson DC-Nevada, No 2:19-CV-674.

The IRS Cryptocurrency Letter

Do you Bitcoin?

The issue actually involves all cryptocurrencies, which would include Ethereum, Dash and so forth.

A couple of years ago the IRS won a case against Coinbase, one of the largest Bitcoin exchanges. The IRS wasn’t going after Coinbase per se; rather, the IRS wanted something Coinbase had: information. The IRS won, although Coinbase also scored a small victory.

·       The IRS got names, addresses, social security numbers, birthdates, and account activity.

·       Coinbase however provided this information only for customers with cryptocurrency sales totaling at least $20,000 for years 2013 to 2015.

What happens next?

You got it: the IRS started sending out letters late last month- approximately 10,000 of them. 

Why is the IRS chasing this?

The IRS considers cryptocurrencies to be property, not money. In general, when you sell property at a gain, the IRS wants its cut. Sell it at a loss and the IRS becomes more discerning. Is the property held for profit or gain or is it personal? If profit or gain, the IRS will allow a loss. If personal, then tough luck; the IRS will not allow the loss.

The IRS believes there is unreported income here.

Yep, probably is.

The tax issue is easier to understand if you bought, held and then sold the crypto like you would a stock or mutual fund. One buy, one sell. You made a profit or you didn’t.

It gets more complicated if you used the crypto as money. Say, for example, that you took your car to a garage and paid with crypto. The following weekend you drove the car to an out-of-town baseball game, paying for the tickets, hotel and dinner with crypto. Is there a tax issue?

The tax issue is that you have four possible tax events:

(1)  The garage

(2)  The tickets

(3)  The hotel

(4)  The dinner

I suspect that are many who would be surprised that the IRS sees four possible triggers there. After all, you used crypto as money ….

Yes, you did, but the IRS says crypto is not money.

And it raises another tax issue. Let’s use the tickets, hotel and dinner for our example.

Let’s say that you bought cryptos at several points in time. You used an older holding for the tickets. 

You had a gain on that trade.

You used a newer holding for the hotel and dinner.

You had losses on those trades.

Can you offset the gains and losses?

Remember: the IRS always participates in your gains, but it participates in your losses only if the transaction was for profit or gain and was not personal.

One could argue that the hotel and dinner are about as personal as you can get.

What if you get one of these letters?

I have two answers, depending on how much money we are talking about.

·       If we are talking normal-folk money, then contact your tax preparer. There will probably be an amended return. I might ask for penalty abatement on the grounds that this is a nascent area of tax law, especially if we are talking about our tickets, hotel and dinner scenario.

·       If crazy money, talk first to an attorney. Not because you are expecting jail; no, because you want the most robust confidentiality standard available. That standard is with an attorney. The attorney will hire the tax preparer, thereby extending his/her confidentiality to the preparer.

If the IRS follows the same game plan as they did with overseas bank accounts, anticipate that they are looking for strong cases involving big fish with millions of dollars left unreported.

In other words, tax fraud.

You and I are not talking fraud. We are talking about paying Starbucks with crypto and forgetting to include it on your tax return.

Just don’t blow off the letter.

A College Student and Ethereum

I have passed on Bitcoin and other cryptocurrencies.

I do not quite understand them, nor am I a Russian oligarch or Chinese billionaire trying to get money out of the country.

I certainly do not think of them as money.

The IRS agrees, having said that cryptos are property, not money.

This has very significant tax consequences.

I can take $100 out of my bank and pay cash at the dry cleaners, Starbucks, Jimmy John’s and Kroger without triggering a tax event.

Do that with a crypto and you have four taxable events.

That is the difference between property and money.

COMMENT: To be fair, money (that is, currency) can also be bought and sold like property. That is what the acronym “forex” refers to. It happens all the time and generally is the province of international companies hedging their cash exchange positions. Forex trading will trigger a tax consequence, but that is not what we are talking about here.

I am reading about a college student who in 2017 invested $5,000 in Ethereum, a cryptocurrency.

Within a few months his position was worth approximately $128,000.

He diversified to other cryptos (I am not sure that counts as diversification, truthfully) and by the end of the year he was closing on $900 grand.

Wow!

2018 has not been kind to him, however, and now he is back to around $125 grand.

Do you see the tax problem here?

Yep, every time he traded his crypto the IRS considered it taxable as a “sale or exchange” of property.

Maybe it is not that bad. Maybe he only traded two or three times and can easily pay the taxes from his $125 grand.

He estimates his 2017 taxes to be around $400 grand.

Seems a bit heavy to me, but let’s continue.

Does the IRS know about him?

Yep. Coinbase issued him a 1099-K reporting his crypto trades. Think of a 1099-K as the equivalent of a broker reporting your stock trades on a 1099-B.

He argues that he reinvested all his trades. He never took a personal check.

I don’t think he quite understands how taxes work. Try telling the IRS that you did not have taxable income upon the sale of your Apple stock because you left all the money in your brokers’ account.

He says that he reached out to a tax attorney – one who specializes in crypto.

I am glad that he sought professional help, whether attorney, CPA or EA.

I however doubt that the attorney’s crypto expertise is going to move the needle much. What he needs is a someone with expertise in IRS procedure, as he is rushing toward an installment plan, a partial pay or offer in compromise.

After all, he is not paying the $400 grand in taxes with what he has left.

The New Qualified Business Deduction

I spent a fair amount last week looking over the new IRS Regulations on the qualified business deduction. It was a breezy and compact 184 pages, although it reads longer than that.

I debated blogging on this topic. While one of the most significant tax changes in decades, the deduction is difficult to discuss without tear-invoking side riffs. 

But – if you are in business and you are not a “C” corporation (that is, the type that pays its own taxes) - you need to know about this new deduction.

Let’s swing the bat:

1.    This is a business deduction. It is 20% of something. We will get back to what that something is.

2.    There historically has been a spread between C-corporation tax rates and non-C-corporation tax rates. It is baked into the system, and tax advisors have gotten comfortable understanding its implications. The new tax law rattled the cage by reducing the C-corporation tax rate to 21%. Without some relief for non-C-corporation entities, lawyers and accountants would have had their clients folding their S corporation, partnership and LLC tents and moving them to C-corporation campgrounds.

3.    It is sometimes called a “passthrough” deduction, but that is a misnomer. It is more like a non-C-corporation deduction. A sole proprietorship can qualify, as well as rentals, farms and traditional passthroughs like S corporations, LLCs and partnerships. Heck even estates and trusts are in on the act.

4.    But not all businesses will qualify. There are two types of businesses that will not qualify:

a.     Believe it or not, in the tax world your W-2 job is considered a trade or business. It is the reason that you are allowed to deduct your business mileage (at least, before 2018 you were). Your W-2 however will not qualify for purposes of this deduction.

b.    Certain types of businesses are not invited to the party: think doctors, dentists, lawyers, accountants and similar. Think of them as the “not too cool” crowd.

                                                   i.There is however a HUGE exception.

5.   Congress wanted you to have skin in the game in order to get this 20% deduction. Skin initially meant employees, so to claim this deduction you needed Payroll. At the last moment Congress also allowed somebody with substantial Depreciable Property to qualify, as some businesses are simply not set-up with a substantial workforce in mind. If you do not have Payroll or Depreciable Property, however, you do not get to play.

a.     But just like (4)(b) above, there is a HUGE exception.

6.   Let’s set up the HUGE exception:

a.     If you do not have Payroll or Depreciable Property, you do not get to play.

b.    If you are one of “those businesses” - doctors, dentists, lawyers, accountants and similar - you do not get to play.

c.     Except …

                                                   i. … if your income is below certain limits, you still get to play.

                                                 ii. The limit is $157,500 for non-marrieds and $315,000 for marrieds.

                                              iii. Hit the limit and you provoke math:

1.    If you are non-married, there is a phase-out range of $50 grand. Get to $207,500 and you are asked to leave.

2.    If you are married, double the range to $100 grand; at $415,000 you too have to leave.

                                               iv. Let’s consider an easy example: A married dentist with household taxable income of less than $315,000 can claim the passthrough deduction, as long as the income is not from a W-2.

1.    At $415,000 that dentist cannot claim anything and has to leave.

                                                 v. Depending on the fact pattern, the mathematics are like time-travelling to a Led Zeppelin concert. The environment is familiar, but everything has a disorienting fog about it.

1.    Why?

a.     The not-too-cool crowd has to leave the party once they get to $207,500/$415,000.

b.    Simultaneously, the too-cool crowd has to ante-up either Payroll and/or Depreciable Property as they get to $207,500/$415,000. There is no more automatic invitation just because their income is below a certain level.

c.     And both (a) and (b) are going on at the same time.

                                                                                                               i.     While not Stairway to Heaven, the mathematics are … interesting.

7.    The $207,500/$415,000 entertainment finally shows up: Payroll and Depreciable Property. Queue the music.

a.     The deduction starts at 20% of the specific trade or business’s net profit.

b.    It can go down. Here is how:

                                                   i. You calculate half of your Payroll.

                                                 ii. You calculate one-quarter of your Payroll and add 2.5% of your Depreciable Assets.

                                              iii. You take the bigger number.

                                               iv. You are not done. You next take that number and compare it to the 20% number from (a).

                                                 v. Take the smaller number.

c.     You are not done yet.

                                                   i. Take your taxable income without the passthrough deduction, whatever that deduction may someday be. May we live long enough.

                                                 ii. If you have capital gains included in your taxable income, there is math. In short, take out the capital gain. Bad capital gain.

                                              iii. Take what’s left and multiply by 20%.

                                               iv. Compare that number to (7)(b)(v).

1.    Take the smaller number.

8.    Initially one was to do this calculation business by business.

a.     Tax advisors were not looking forward to this.

b.    The IRS last week issued Regulations allowing one to combine trades or businesses (within limits, of course).

                                                   i. And tax advisors breathed a collective sigh of relief.

c.     But not unsurprisingly, the IRS simultaneously took away some early planning ideas that tax advisors had come up with.

                                                   i. Like “cracking” a business between the too-cool and not-too-cool crowds.  

And there is a high-altitude look at the new qualified business deduction.

If you have a non-C-corporation business, hopefully you have heard from your tax advisor. If you have not, please call him/her. This new deduction really is a big deal.