Find out why an old law is still relevant for using like-kind exchange (LKE) for crypto returns before the 2018 tax year.
Like-kind exchange (LKE) can still be used for cryptocurrencies for returns before the 2018 tax year (Footnote 1). Returns can be amended to add Form 8824 to report like-kind exchange (LKE) exchange transactions that had never been reported. The purpose of doing this is to avoid the risk of an audit of unreported income and associated penalties and interest. The penalties include a 20-40% accuracy penalty.
Returns that had reported crypto-to-crypto trades on Form 8949 can be amended to reduce tax liabilities or claim refunds for 2017. I have gotten refunds of over $396,000 by doing this for clients.
In December 2017, Congress passed the TCJA bill, which among many other things, limited the use of like-kind exchange (LKE) to real property like land or buildings.
The like-kind exchange (LKE) section has been in the tax code since 1921, with only minor changes (footnote 2). The purpose of the law was to promote investment by not taxing exchanges unless there was a distribution of gain. For this reason, the courts have taken a liberal view to interpret the laws to the benefit of taxpayers (footnote 3).
In the original version of the 1921 law, property had to be held for at least two years before benefiting tax-deferred exchange. The purpose of the holding period was to differentiate between speculative and investment property (footnote 4). In 1924, the law was changed to require the property to be of like-kind exchange (LKE) to receive deferred tax treatment (footnote 5).
As a result of losses in court, the IRS has issued many administrative rulings to reign in abuse. The Volker Report identified aggressive use of Section 1031 as distorting the financial system leading up to the 2008-2009 financial crisis (footnote 6).
By 2014, several concerns were being raised. The sharp increase in deferred gain reported on Form 8824 meant that too much tax was being avoided by like-kind exchange (LKE). Another ongoing concern is that like-kind exchange (LKE) allowed the investments to grow without tax until the investor died. After that, they could also be transferred tax-free to an inheritor. This last concern became compounded by the rise of cryptocurrencies, which allowed the investor the possibility to never return to fiat and be taxed.
The statute of limitations is a legal time limit on how long the IRS has to find errors in a tax return. It is a form of taxpayer protection. The primary limit is three years after a return’s filing due date (footnote 7). The second limit is two years after all tax liabilities are paid. This second limit doesn’t affect people who pay off their taxes on the due date.
However, if a return is fraudulent or was a willful attempt not to pay taxes, then there is no statute of limitations. Crypto traders who intentionally didn’t report their crypto gains in 2017 or other years are at risk. The amount of income hidden would have to be significant for the IRS to press this claim.
Another exception is if the unreported income is related to foreign financial assets and is greater than $5000. When this happens, the statute of limitations on auditing is six years (footnote 8). What is a foreign financial asset? An asset is considered foreign when the issuer or counterparty is other than a U.S. person (footnote 9). When you trade on a non-SEC registered crypto exchange, your trades are matched up with an anonymous person whom you can not prove is a U.S. person; therefore, you have to assume that he is not a U.S. person (footnote 10).
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