On June 18, 2021, the IRS issued IRS Legal Memo 202124008, in which it concludes that swaps of certain cryptocurrencies cannot qualify as tax-deferred “like-kind” exchanges under Section 1031 of the Code as it existed prior to its amendment in 2017.

Under Section 1031, taxpayers may defer tax on gains when they sell certain property and reinvest the proceeds into similar property (so-called like-kind exchanges). For exchanges occurring on or after January 1, 2018, the Tax Cuts and Jobs Act (TCJA) limited the availability of Section 1031 to exchanges of real property, excluding all other property, including cryptocurrency.

Before being amended by the TCJA, Section 1031 was available for exchanges of many forms of property, provided the taxpayer bought property that counts as like-kind to what the taxpayer sold. We understand that many investors in cryptocurrency took the position that swaps of one cryptocurrency for another qualified for tax deferral under Section 1031, a position the Memo directly disputes.

As discussed in the Memo, in the context of personal property (such as cryptocurrency), the rules for determining what is like-kind are much more narrow than those for real property, and require the replacement property to be very similar to the property sold.

Section 1.1031(a)-1(b) of the Treasury Regulations defines “like kind” to mean the nature or character of the property and not the grade or quality, and provided that one kind or class of property may not be exchanged for property of a different kind or class. Prior IRS guidance interprets this rule narrowly. For example, in Revenue Ruling 82-166, the IRS held that gold bullion is not like-kind to silver bullion because the value of silver is derived largely from industrial uses whereas the value of gold is derived largely from investment and speculation. Further, in Revenue Ruling 79-143, the IRS held that numismatic-type coins (ie, coins deriving value from age, scarcity, history, or aesthetics) are not like-kind to bullion-type coins (ie, coins deriving value from metal content). In the Memo, the IRS applied these authorities to exchanges of Bitcoin for Litecoin, of Ether for Litecoin, and of Bitcoin for Ether.

For exchanges involving Litecoin, the Memo describes the unique role that Ether and Bitcoin play with respect to such exchanges. In order to acquire Litecoin, a trader generally must give Bitcoin or Ether in exchange, and in order to sell Litecoin, a trader generally must receive Bitcoin or Ether in exchange. The Memo notes that “[u]nlike other cryptocurrencies, Bitcoin and Ether acted as an on and off-ramp for investments and transactions in other cryptocurrencies.” Because of this difference, Bitcoin and Ether, according to the IRS, each differed in both nature and character from Litecoin, and therefore do not qualify as property that is like-kind with Litecoin. As a result, the Memo concludes that exchanges of Litecoin for Bitcoin or Ether are not eligible for Section 1031 tax-deferred exchange treatment.

For exchanges of Bitcoin and Ether, the Memo again notes their unique position in the cryptocurrency market, but nevertheless concludes that “while both cryptocurrencies share similar qualities and uses, they are also fundamentally different from each other because of the difference in overall design, intended use, and actual use,” and thus are not like-kind with respect to each other. Specifically, the IRS noted that the Bitcoin network is designed to act as a payment network, with Bitcoin being the unit of payment, while the Ethereum blockchain is both a payment network and a platform for operating smart contracts and other applications, with Ether facilitating those features. As a result, the Memo concludes that exchanges of Bitcoin for Ether (or vice versa) are not eligible for Section 1031 tax-deferred exchange treatment.

While the Memo only addresses exchanges of three specific cryptocurrencies, it seems reasonable to assume that the IRS would apply its analysis in the Memo to most other cryptocurrencies. For taxpayers who swapped cryptocurrencies on or before December 31, 2017, and took the position that such exchanges qualified for tax deferral under Section 1031, if the IRS’s position in the Memo is sustained, those taxpayers may be liable for back taxes, interest and/or penalties for those transactions. Potentially affected taxpayers should consult their tax advisors to discuss implications of the Memo, including whether the statute of limitations remains open and whether the taxpayer should file amended tax returns.