On November 3, 2021, the U.S. House Budget Committee introduced the latest version of the Build Back Better legislation (the “BBB Legislation” or “BBB Act”), which makes historical investments in education, climate change, and the economy. Although much has been written on the surcharge for certain high-net-worth individuals and a global minimum tax on corporations, other proposed changes in the legislation to the tax code stand to create ripple effects throughout the crypto ecosystem. We discuss the direct and indirect tax impact of the BBB Legislation for crypto investors, miners/validators, and other players further below.
Direct Tax Impact on Cryptocurrency – Wash Sale and Constructive Sales
The BBB legislation takes further steps to treat cryptocurrencies like traditional securities by subjecting all digital assets to the (A) wash sale rules under Section 1091 and (B) constructive sale rules under Section 1295 of the Code. The new wash sale rules would be effective after December 31, 2021, and the amended constructive sale rules would apply as of the date of enactment.
Wash Sale Rules
As it currently stands, the wash sale rules do not apply to cryptocurrencies because such assets are treated as property rather than securities under Notice 2014-21 for federal tax purposes. Under the wash sale rules, losses are disallowed on the sale of stock if the taxpayer acquired a “substantially identical” stock either 30 days prior or 30 days after such sale. Instead, the amount of the disallowed loss is added to the basis of the acquired stock and the loss is generally recognized at the time the acquired stock is ultimately sold. The holding period of the security from the sale resulting in the disallowed loss carries over to the reacquired security.
Since cryptocurrencies do not currently fall within the wash sale rules, taxpayers can obtain a substantial tax benefit by recognizing a loss on the sale of crypto tokens and immediately buying back the same crypto assets. To illustrate the magnitude of this benefit, suppose Paul owns one Ether coin worth $1,000, which he purchased more than a year ago for $4,000. On November 1st, he sells the coin for $1,000 and recognizes a $3,000 loss on the sale. Paul immediately buys back the Ether coin at $1,000. On November 10th, the value of the Ether coin skyrockets to $5,000. Under this scenario, Paul not only gets the benefit of the $3,000 loss to offset other capital gains from his portfolio, but also continues to capture any upside on the Ether coin, which in this case, is the $1,000 of built-in gain.
The proposed legislation would disallow and defer Paul’s initial $3,000 loss upon the sale of his Ether coin. Instead, Paul would be required to add the loss to the basis of the re-acquired Ether token, meaning that he would take a basis in the purchased coin of $4,000. Paul could only utilize the $3,000 loss from the November 1st sale when he sells the token on November 11th for $5,000. Ultimately, Paul would recognize a $1,000 gain on the November 11th sale. Since the holding period of the Ether coin Paul sold on November 1st was more than a year, his gain upon the sale of the Ether token on November 11th would be taxed at the more preferential long-term capital gains rate.
Constructive Sale Rules
The BBB legislation also extends the constructive sale rules to digital assets. Under Section 1259, a taxpayer will be treated as having constructively sold an “appreciated financial position” (“AFP”) if that taxpayer (or a related person) hedges the position by entering into a short sale and offsetting notional principal contract, a forward contract, or a similar transaction with respect to the same or substantially identical property. Additionally, an appreciated financial position created through a short sale would be deemed to be constructively sold if the taxpayer enters into an offsetting notional principal or futures contract to acquire the same or substantially identical property. The constructive sale rules are designed to prevent taxpayers from “locking in” the unrealized gain of an AFP without any gain recognition by taking an offsetting position. Again, an example is useful to illustrate the rationale for the rule. Assume that Sarah acquires 1 Solana coin for $90. Three months later, the value of a Solana coin increases to $300. At this point, Sarah thinks the price per coin will decline and open a short position in Solana. As part of the position, Sarah borrows 1 Solana coin from a lender and sells it for $300. A week later, the price per Solana coin declines to $250 per token. As long as both positions remain open, Sarah will recognize no economic gain because the $50 decline in the value of her long position is entirely offset by a corresponding $50 increase in value of her short position, which effectively locks in her $210 unrealized gain ($300 value at sale – $90 original cost basis) regardless of price fluctuations. To further illustrate, assume that the value per Solana coin decreases to $70. Sarah would have an unrealized gain of $230 on her short position and a loss of $20 on her long position ($70 value – $90 cost basis) for a total unrealized gain of $210. In this respect, Sarah is able to guarantee her $210 of unrealized gain without triggering a recognition event (and the resulting taxes).
Under the proposed legislation, Sarah would be deemed to sell her Solana coin (i.e., her long position) on the date she opens the short position. Thus, Sarah would recognize a $210 gain ($300 value – $90 cost basis) on the deemed sale of the Solana coin. She would continue to own the coin and take a cost basis of $300 in the Solana coin. When the coin declines to $70, Sarah would have an unrealized gain because the loss from the deemed sale of her long position ($70 value – $300 deemed cost basis) will be entirely offset by the corresponding gain of her short position ($300 in sales proceeds – $70 value). The difference, however, is that Sarah would be required to immediately recognize and pay taxes on the constructive sale of her AFP upon opening her short position in the Solana coin.
Indirect Tax Impact for Cryptocurrencies
The BBB Act also makes broad-based changes to the federal tax code that may indirectly impact crypto investors and miners/validators. These changes include (A) a new surcharge on certain high-income individuals, estates, and trusts, and (B) increased funding for IRS enforcement. We discuss the potential tax implications of each of these proposed changes on the crypto industry further below.
Surcharge on High-Income Individuals, Estates, and Trusts
The proposed legislation seeks to raise $280 billion over a ten-year period by imposing a surcharge on high-net-worth individuals, estates, and trusts above a certain income threshold. Specifically, individuals and trusts/estates with a “modified adjusted gross income” (“MAGI”) exceeding $10 million (or $5 million for a married individual filing separately) and $200,000, respectively, are required to pay a 5% surcharge in addition to their normal income taxes. An additional 3% surcharge is imposed for individuals and trusts/estates with MAGI of $25 million (or $12.5 million in the case of married individuals filing separately) and $500,000, respectively. For purposes of the surcharge, MAGI is adjusted gross income less any business/investment interest for individuals and certain estate administration and charitable deductions in the case of trusts/estates.
Taxpayers that earn tokens for performing mining/staking activities or who will see a substantial jump in income upon the sale of their crypto holdings may be subject to these surcharges (in addition to taxes at a higher income bracket). If the BBB Act is ultimately enacted in its current form, taxpayers in these situations will want to ensure they have set aside enough cash to pay the higher taxes (including any required quarterly estimated taxes). This is especially true if taxpayers do not liquidate their crypto holdings for cash, but exchange cryptocurrencies for other cryptocurrencies, which will trigger a taxable event under Notice 2014-21.
Increased Funding for IRS Enforcement
The BBB legislation also appropriates roughly $80 billion for IRS operations and taxpayer services, approximately $45 million of which is devoted to beefing up IRS enforcement, including “provid[ing] digital asset monitoring and compliance activities.” The increased funding for IRS enforcement, paired with enhanced crypto reporting requirements in the recently passed infrastructure bill, will surely result in more IRS audits and enforcement actions for crypto investors and miners/validators alike.
The tax changes in the BBB Act, if enacted, will have a significant direct and indirect impact on all participants in the crypto industry. As discussed above, the amended wash sale and constructive sale rules are designed to treat cryptocurrencies like securities and limit taxpayers from engaging in potentially abusive transactions solely for the tax benefits. In addition, a new surcharge on certain high-net-worth individuals and trusts/estates and increased funding for IRS enforcement will surely subject crypto earnings to more taxes and IRS scrutiny.