Over the past few years, cryptocurrencies such as Bitcoin and Ethereum have received the lion’s share of attention from crypto enthusiasts and investors, sending the price of these coins to new highs. The price of cryptocurrencies, however, is notoriously volatile. At any given moment, their prices can experience wild swings based on a regulatory crackdown from a country, an announcement of a hard fork upgrade, or even a tweet. This volatility has made the adoption of digital coins as a mainstream currency, on par with the U.S. dollar or other fiat currency, impractical. As a result, despite their popularity, cryptocurrencies continue to be viewed by many as speculative assets rather than a form of currency that can be used to conduct financial transactions. Enter stablecoins.
Stablecoins – digital currencies pegged to a fiat currency or other asset – are increasingly seen as having the stability necessary to foster the widespread acceptance of virtual currencies. But how should transactions involving stablecoins be taxed? As mentioned in past postings, IRS guidance on virtual currencies so far have been limited to Notice 2014-21, which the Service originally issued in 2014 and updated this year amidst surging interest and scrutiny on cryptocurrencies. In this posting, we will briefly describe what stablecoins are and evaluate the tax implications of common stablecoin transactions. Ultimately, in the absence of significant IRS guidance on cryptocurrencies, we hope this posting will provide a general framework for how transactions involving stablecoins should be treated for federal tax purposes.
General Stablecoin Concepts
Stablecoins are viewed as a potential breakthrough for virtual currencies because they combine the price stability of traditional fiat currencies with the advantages of decentralized blockchain networks, including faster money transfers, elimination of intermediaries from financial transactions, and increased access to financial services. Stablecoins can achieve this price stability because they are usually collateralized by fiat currency or another asset. Fiat-backed currencies, as the name suggests, are pegged to a fiat currency such that their intrinsic value is tied to the value of the fiat currency. Nevertheless, any market fluctuations of the pegged fiat currency relative to other fiat currencies are reflected in the value of the stablecoin. In addition, because stablecoins are collateralized by fiat currency reserves, they require a centralized authority such as a bank to be a depository and issuer of the currency reserves. By contrast, for asset-backed stablecoins, users are required to put up a physical or digital asset (e.g., gold or another cryptocurrency) as collateral before they can receive the stablecoins on the blockchain network.
There are also uncollateralized stablecoins that rely on algorithms to stabilize the price of the coins. If the price of stablecoin rises above the predetermined price, the algorithm decreases the price by minting more stablecoins. Conversely, if the price falls below the desired price, then the algorithm decreases the supply of coins to increase the price. Unlike fiat-or-collateral backed stablecoins, users typically receive algo-backed stablecoins through airdrops, which are distributions of coins by a startup blockchain network for purposes of marketing a newly-circulated stablecoin.
Taxation of Stablecoin Transactions
Given that taxpayers primarily use stablecoins as a means of conducting financial transactions on decentralized blockchain networks, the rest of this posting will provide an overview of three common stablecoin transactions occurring on these networks: (1) stablecoin issuance, (2) the exchange of stablecoins for other cryptocurrencies, and (3) the redemption of stablecoins.
As with other cryptocurrency tax matters, Notice 2014-21 is a useful starting point for evaluating the tax implications of stablecoin transactions. In particular, the IRS has made clear that cryptocurrencies are considered property for federal tax purposes and that an exchange of cryptocurrency for another cryptocurrency is a taxable event. Tax practitioners can draw on these concepts to infer how the stablecoin transactions mentioned above should be taxed, but important questions do remain.
The tax consequences relating to the issuance of stablecoins are dependent on what type of coin is being issued. For fiat-backed stablecoins, a user will exchange fiat currency for stablecoins. This exchange should not be treated as a taxable event since the transaction can be viewed as a conversion of fiat currency into digital form. However, even if the transaction gives rise to a taxable event, there should be no resulting gain (or loss) because fiat currency is being exchanged for an equivalent value of fiat-backed stablecoins.
Likewise, under traditional tax principles, a taxpayer’s receipt of collateral-backed stablecoins should not be taxable. In this transaction, the user is merely putting up physical or digital assets as collateral for the receipt of stablecoins. No exchange is arguably taking place, as the taxpayer receives his collateral back upon the redemption of the stablecoins. On the other hand, the Service’s position that exchanges of cryptocurrency (for another cryptocurrency) are taxable may complicate this argument. For example, suppose a taxpayer had an unrealized gain on cryptocurrency she placed as collateral for stablecoins. Should that taxpayer be required to recognize gain on the cryptocurrency at the time she puts it up as collateral? If so, should the gain be limited to the amount of cryptocurrency required to collateralize 100% of the stablecoins? Given the tension between traditional tax principles and IRS guidance in Notice 2014-21, the answer is not entirely clear.
What is more clear is that users who receive algo-backed stablecoins through airdrops would be taxed upon receipt of the coins. The amount of tax would equal the difference between the fair market value and cost basis of the coins at issuance. In practice, taxpayers should recognize little to no tax since airdrops are usually done in the course of promoting the stablecoin and thus have nominal value upon issuance.
Exchange of Stablecoins
An exchange of stablecoins for cryptocurrency or other property should be taxable under the Notice regardless of the type of stablecoin issued. Again, in an exchange of fiat-backed currency, there should be no resulting tax since the taxpayer received stablecoins in exchange for an equal value of fiat currency. In this regard, the transaction should be treated similarly to a purchase of property with fiat currency.
An exchange of collateral-backed stablecoins should also be a taxable event, but the open question, as alluded to above, is the timing of taxation. For instance, assume that a taxpayer puts $1,500 worth of Cardano as collateral for stablecoins worth $1,000. Further assume that the taxpayer acquired the Cardano tokens two years ago for $100. The taxpayer then exchanges the stablecoins for one Ethereum coin worth $1,500. Should all or any portion of the $1,400 of built-in gain that the taxpayer has in the Cardano tokens be triggered at the time he puts it up as collateral? Or should the taxpayer recognize the gain upon the exchange of Cardano tokens for one Ethereum coin? The ladder would allow taxpayers to potentially defer any gain, which may have implications on whether the gain is taxed as short or long-term capital gains.
The exchange of algo-backed stablecoins can potentially result in the most gain, depending on the predetermined value of the coin. This is because users typically receive the coins when they have little to no value. Thus, if the algo-backed stablecoin increases in value between the time of issuance and exchange, taxpayers will essentially be taxed on the entire increase in value.
Redemption of Stablecoins
From a federal tax perspective, the redemption of stablecoins should be treated similarly as the issuance of stablecoins. In the case of fiat-backed stablecoins, upon the redemption of the stablecoins, a smart contract will burn the redeemed coins and transfer the fiat currency back to the taxpayer. Given that one stablecoin should equal the value of the one unit of fiat currency, no gain or loss should result from the redemption.
Similarly, because taxpayers are simply receiving their collateral back once they redeem the collateral-backed coins, there should theoretically be no gain or loss to the taxpayer. But what should the tax consequences be if a precipitous decline in the collateral cryptocurrency or property result in an under-collateralization of the issued stablecoins? In such a scenario, the network would force a sale of the collateral to buy back the issued stablecoins, with any remaining collateral transferred back to the taxpayer. The taxpayer should recognize any gain or loss on the forced sale of the collateral.
Finally, since there is no fiat currency or other collateral backing up algo-backed stablecoins, the coins can not be redeemed, but only exchanged for other cryptocurrencies or property. As already mentioned above, the exchange should result in a taxable event, with the taxpayer typically being taxed on the increase in value of the stablecoins between issuance and exchange.
In sum, the tax consequences of stablecoin transactions seemingly depends on what type of stablecoin is being issued. Generally, fiat-backed stablecoin transactions result in little to no tax, while collateral-backed and algo-backed coins trigger gain or loss in certain scenarios. Hopefully, future IRS guidance can help answer outstanding questions on the taxation of stablecoins, but in the absence of such guidance, Notice 2014-21 and traditional tax principles can provide some guardrails on how stablecoin transactions should be taxed.
Have cryptocurrency or blockchain issues or questions? Freeman Law is an innovative thought leader in the blockchain and cryptocurrency space. Blockchain and virtual currency activities take place in a rapidly evolving regulatory landscape. Freeman Law is dedicated to staying at the forefront as these emerging technologies continue to revolutionize social and economic activities. Contact Freeman Law to schedule a consultation or call (214) 984-3000 to discuss your cryptocurrency and blockchain technology concerns.