On June 18, 2021, the Internal Revenue Service (the IRS) Office of Chief Counsel released Memorandum 202124008 addressing the application of Internal Revenue Code (Code) Section 1031 to exchanges of certain cryptocurrencies that occurred prior to the Tax Cuts and Jobs Act (TCJA). The TCJA, P.L. 115-97, amended Section 1031 of the Code to provide that like-kind exchange treatment applies only to real property. The memorandum addressed the following question: If completed prior to January 1, 2018, does an exchange of (i) bitcoin for ether, (ii) bitcoin for litecoin, or (iii) ether for litecoin (each a Described Exchange) qualify as a like-kind exchange under Section 1031 of the Code? The IRS concluded that each Described Exchange did not qualify as a like-kind exchange under Section 1031 of the Code.

The IRS referenced Notice 2014-21 treating virtual currency as property for federal income tax purposes and thus subject to general tax principles applicable to property transactions. Citing Rev. Rul. 2019-24, the IRS noted that virtual currencies such as Bitcoin, Ether, and Litecoin are cryptocurrencies because they depend on cryptography to secure transactions that are digitally recorded on a distributed ledger. The IRS highlighted the characteristics and functionality of each cryptocurrency, focusing on (a) overall design, (b) intended use, and (c) actual use in analyzing each Described Exchange.  

Notably, in addition to cryptocurrencies being used as a method of payment, the IRS acknowledged that taxpayers make investments in a variety of cryptocurrencies and some cryptocurrencies may be exchanged for fiat currencies, while others may only be exchanged for certain types of cryptocurrencies.

While taxpayers cannot rely on the memorandum, it is still helpful for parties who take the position that their exposure to cryptocurrencies is unrelated to any trade or business and only relates to investment activities.    

In resolving the question as to whether Section 1031 of the Code applies to each Described Exchange occurring prior to January 1, 2018, the IRS explained that Section 1031(a)(1), which provides that “[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment,” applies only to a transaction where the taxpayer’s economic situation is essentially the same as the taxpayer’s economic situation prior to the transaction. Treas. Reg. § 1.1031(a)-1(b) defines “like kind” for purposes of Section 1031(a) of the Code as “the nature or character of the property and not the grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class.” The IRS cited Rev. Rul. 82-166 where the exchange of gold bullion for silver bullion resulted in gain recognition partly because the latter was used primarily as a commodity and the former was used primarily as an investment. The IRS also cited Rev. Rul. 79-143 where the exchange of gold coins for gold coins was considered taxable because one type of gold coin was valued for its collectability and the other was valued for its metal content. While taxpayers cannot rely on the memorandum, it is helpful that the IRS has used these rulings on commodities to assist it in the interpretation of Section 1031 of the Code, particularly for taxpayers relying on existing commodity determinations in respect of other provisions of the Code.  

The IRS compared Bitcoin and Ether to Litecoin, concluding that Bitcoin and Ether had a fundamentally different role in the broader cryptocurrency market from 2016 to 2017, highlighting that “Bitcoin and Ether acted as an on and off-ramp for investments and transactions in other cryptocurrencies” because in order to invest in cryptocurrency or liquidate an investment, an investor would have needed to acquire either bitcoin or ether first. In contrast, the IRS noted that litecoin was substantially more limited when it came to trading. As a result of that difference, the IRS concluded that neither the exchange of bitcoin for litecoin or ether for litecoin qualified for like-kind exchange treatment due to the differing nature and character of the cryptocurrencies involved. Taxpayers should note that given the various uses or functions that cryptocurrencies can serve, apart from a possible investment, a critical analysis of all the ultimate facts and circumstances is necessary. The use of a cryptocurrency, for example, to perform a service-like function could be viewed as a trade or business that is beyond mere investment.   

In respect of the exchange of bitcoin for ether, even though the IRS acknowledged that both had a similar role in the cryptocurrency market and had similar qualities and uses, the IRS noted that Bitcoin “is designed to act as a payment network for which Bitcoin acts as the unit of payment” whereas Ether was intended to act not only as a payment network but “as a platform for operating smart contracts and other applications.” Thus, the different functionalities of bitcoin and ether led the IRS to conclude that the exchange of one for the other would not qualify as like-kind property under Section 1031 of the Code. 

The memorandum addressed only exchanges of bitcoin for ether, bitcoin for litecoin, and ether for litecoin.