&l;em&g;The IRS wants a share of the billions made last year. This is going to get ugly.&l;/em&g;
&l;img class=&q;dam-image getty size-large wp-image-932379114&q; src=&q;https://specials-images.forbesimg.com/dam/imageserve/932379114/960×0.jpg?fit=scale&q; data-height=&q;640&q; data-width=&q;960&q;&g; Bitcoin shop in Krakow (Beata Zawrzel/NurPhoto via Getty Images)
What do you do, come April 17, if you made a ton of money trading crypto last year and have since lost most of it? Panic, probably.
A lot of last year&a;rsquo;s winners are in deep porridge now. They owe tax on 2017 profits. They&a;rsquo;re losing money now, so it&a;rsquo;s not easy to come up with the cash to pay off the IRS. As for using today&a;rsquo;s losses to offset last year&a;rsquo;s gains, these tax na&a;iuml;fs are discovering, too late, that capital loss carryovers run forwards but not backwards.
Suppose speculator Bob turned $200,000 into $1 million in last year&a;rsquo;s feverish market, trading all the way&a;mdash;in and out of Bitcoin and Ethereum and Ripple and back in again. Now Bob has $800,000 in short-term capital gain to report on Schedule D. The state and federal tax bill is going to be upwards of $300,000.
The 2018 crash has shrunk Bob&a;rsquo;s account value, let us suppose, to $300,000. If Bob sells out to pay the tax, he will have a $700,000 capital loss to claim. But he can claim the loss only against future capital gains, not past ones.
Small consolation: Bob can use the $700,000 against up to $3,000 a year of ordinary income. If he throws in the towel on cryptocurrencies and goes back to his day job delivering pizzas, it will take him 234 years to catch even.
Tyson Cross, an attorney in Reno, Nev. (and a &l;a href=&q;http://forbes.com/sites/tysoncross&q;&g;Forbes.com contributor&l;/a&g;) who has built up a specialty in &l;a href=&q;http://bitcointaxsolutions.com&q; target=&q;_blank&q;&g;crypto taxation&l;/a&g;, has been hearing many a sad tale recently. &a;ldquo;Some alt coins are down to a tenth or less of their peak value,&a;rdquo; he says. &a;ldquo;The taxpayers are distraught. They don&a;rsquo;t have any way to pay . There&a;rsquo;s only so much we can do.&a;rdquo;
Quite apart from the dollars owed, dealing with the paperwork can be quite a burden. Some investors have bots placing trades all day long, and a single buy or sell might be executed at an exchange via multiple transactions of fractional coins. Cross is working on one tax return with 1.4 million trades.
Evidently a lot of speculators are new to Schedule D. &a;ldquo;They are shocked to find out that, even though they never took funds out in , they have crypto gains to report,&a;rdquo; says Jon Lerner, the chief technology officer of &l;a href=&q;http://Cointracker.io&q; target=&q;_blank&q;&g;CoinTracker.io&l;/a&g;, a portfolio and tax manager for cryptocurrency investors.
If they use an algorithm to place the orders, investors may even be unaware of how much they are trading. One CoinTracker client signed up for the firm&a;rsquo;s low-budget service that allows a maximum of 100 transactions. He provided links to his exchange accounts, and then got a surprise. Turns out he has 200,000 entries to put on his 1040.
How are these currency newbies coping? There are several strategies.
&l;em&g;Play the like-kind lottery.&l;/em&g; Section 1031 of the tax code permits a deferral of tax when one investment property is swapped for another of a similar sort. It works when you exchange one plot of land for another. What about Bitcoin for Ethereum?
For 2018 and later tax years, the law is clear: No tax-deferred exchanges on anything but real estate. For 2017, the law is murky. If the like-kind deferral proves to be valid for digital coins, and if our hypothetical Bob traded in a way to make his trades into exchanges rather than sales, he would have no $800,000 gain for 2017. Instead, he would report a sale in 2018, assuming he closes out today&a;rsquo;s positions. If the market doesn&a;rsquo;t move further, he&a;rsquo;d owe tax on only $100,000 ($300,000 current value less $200,000 starting point).
It&a;rsquo;s possible that when the IRS and then the Tax Court get around to ruling on the matter, they will decree that one digital coin is &l;em&g;not&l;/em&g; like another. You will have long since filed your 2017 tax return. What do you say on it?
If you want to claim salvation from Section 1031, there&a;rsquo;s a proper way. Make a full disclosure on the return. Attach Form 8824, Like-Kind Exchanges; this form can in turn reference a PDF tabulation containing thousands of entries. Also attach Form 8275, Disclosure Statement, which alerts the IRS that you are taking a position it might not like. The disclosure increases your likelihood of being audited but decreases your likelihood of owing a penalty for understatement of a tax liability.
Now what? Tax lawyer Cross says some taxpayers are hoping the IRS won&a;rsquo;t invest much effort in contesting the Section 1031 treatment of coins, since a win in Tax Court would be relevant only to 2017 and earlier tax years. Those hopes are likely to be dashed. There&a;rsquo;s a lot of tax money at stake, probably running to billions of dollars just for 2017.
To further hedge against an adverse outcome you might want to take one other step. If you are sitting on a pile of old-fashioned currency, send some in to the IRS as a deposit. If you prevail down the road you&a;rsquo;ll get the money back and if you don&a;rsquo;t you won&a;rsquo;t owe interest. (More on deposits &l;a href=&q;http://www.forbes.com/sites/robertwood/2011/10/28/when-fighting-irs-should-you-pay-to-stop-interest&q;&g;here&l;/a&g;.)
Note that Section 1031 is of no help to someone who sells one kind of coin for cash and then uses the cash to buy a second kind of coin.
&l;em&g;Play the coin lottery.&l;/em&g; Some taxpayers, Cross predicts, will file a correct tax return but omit a check to the IRS. They&a;rsquo;re hoping to sell their coins after a rebound. Of course, if the market stays weak&a;mdash;Bitcoin is now struggling to stay above $7,000&a;mdash;they will be in worse shape.
If you file an honest return but don&a;rsquo;t pay, you owe principal plus interest plus a late payment penalty of 0.5% per month.
&l;em&g;Play the audit lottery. &l;/em&g;Both Cross and Lerner sense that a great many new players in crypto are planning to simply make no mention of trading gains on their returns. This is a poor choice. The IRS is gathering records from Coinbase, the leading U.S. exchange for crypto. If you get nailed, you&a;rsquo;re on the hook for back taxes, interest and some nasty penalties.
What if your trading is on Binance, the offshore site? If your account is worth at least $10,000, you are obliged to tell the government about it in an FBAR filing. You were planning to omit that form, too? Then understatement penalties may be the least of your worries. Prepare for a visit to the penitentiary.