Volatility in the crypto market is nothing new. From the bull run of late 2017 and subsequent crash of early 18, to the rollercoaster ride of 2020 brought on by Covid-19, crypto investors have become accustomed to frequent market swings. Savvy traders may be capitalizing on these swings to achieve substantial profit.
The IRS has a special trader tax status for taxpayers who frequently engage in trading. This status includes a special accounting method, not available to the average investor, that can come with substantial tax savings. However, there is a lack of certainty about how this status applies to cryptocurrency traders.
What is Trader Tax Status?
The IRS allows a special Trader Tax Status (TTS) for taxpayers who are “in the business of buying and selling securities.” There is no annual election to be made, nor is there any type of concrete test to guarantee a taxpayer can qualify. The three primary criteria to qualify are: “(1) The taxpayer must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation; (2) The taxpayer’s activity must be substantial; and (3) The taxpayer must carry on the activity with continuity and regularity.”
The big catch here is the term “securities.” To qualify for TTS, the trader must be in the business of trading securities or commodities. The IRS has not yet ruled if cryptocurrencies are securities, commodities, or something else. Other governmental agencies, such as the SEC, have ruled that some cryptocurrencies do meet the definition of securities, while the CFTC has declared BTC and ETH as commodities. Because of this, it’s important to note there is an inherent risk built in for a crypto trader to utilize this status. Ultimately, this issue will be settled by the courts, but that hasn’t happened yet.
There is a rich history of case law around TTS, but none of it specific to crypto. The courts also do not have a trading threshold to qualify. Courts have determined that a trader who conducted 1,569 trades in a year did not qualify for TTS, while a trader with 332 trades did qualify. Both the IRS and the courts have been very reluctant to issue this status, with most cases in the last few decades failing to qualify.
Considering these uncertainties, it seems possible that a full-time crypto trader could qualify, but it is certainly not a guarantee. Having other sources of income will typically work against a taxpayer qualifying. A taxpayer can qualify one year and not the next, or even for part of a year. However, once a taxpayer is deemed to be a trader, they unlock the benefits of TTS. Traders are then eligible to deduct any ordinary and necessary expenses as any other business would under §162. TTS also allows the taxpayer to elect Mark-to-Market treatment.
Mark-to-Market (MtM) is an accounting method sometimes referred to as §475(f), under which the trader is deemed to have sold all securities on the last day of the year at their fair market value (FMV). In essence, the trader is realizing for tax purposes all unrealized gains or losses and reporting them on the tax return as ordinary income and not capital gain/loss. This also allows the taxpayer to deduct losses larger than $3000 against other ordinary income and has the potential to create a Net Operating Loss which can be carried back to prior years.
Again, §475(c) and 475(e) outline that to qualify for this status, the taxpayer must be a trader in securities or a trader in commodities. There is a strong case that major cryptocurrencies, such as bitcoin or Ethereum, would be considered commodities. MtM treatment must be elected no later than the unextended due date of the prior year’s return. So, to elect MtM for calendar year 2021, the election needs to be made on the 2020 tax return no later than April 15th, 2021.
The two main benefits of TTS are the taxpayer’s ability to deduct expenses and elect MtM treatment. A trader it not required to use MtM treatment. Common expenses could include: computers, internet, trading signals, fees, margin interest, legal or accounting, home office, and retirement plans. If the taxpayer does not elect MtM treatment, the income remains a capital gain or loss reported on Schedule D, while the expenses are reported on Schedule C. A taxpayer with TTS may also be eligible for a §199A Qualified Business Income deduction.
Electing MtM changes the nature of the gain from capital income to ordinary income and moves the reporting to Form 4797. This can provide additional benefits to the taxpayer in addition to the ability to claim an ordinary loss. MtM traders lose access to preferred long-term capital gains rates, however, due to the volume and frequency of trades required to elect MtM in the first place it is unlikely an MtM trader would have been able to utilize those rates anyway.
The positives of TTS are not without a downside. MtM traders may end up paying tax on a gain the never realize if a security peaks near the end of the year. This is similar to what many crypto traders experienced in December 2017, realizing high gains on paper. One of the largest benefits of MtM status is the ability to deduct losses against ordinary income. However, if a taxpayer has other sources of ordinary income, they likely would not qualify for the MtM election in the first place.
It’s also critical to keep personal investments separate from business investments. This means a trader should have long-term BTC holdings in a separate wallet and not comingled with the assets that are being traded. This process can also be an uphill battle for the taxpayer to prove they are eligible for TTS. IRS can be quick to disallow the status on audit, requiring the taxpayer to work through appeals or to tax court to prove their case. This route can be costly from a representation and time perspective and in almost all recent cases before the tax court, TTS was denied. The taxpayer can also be assessed a 20% accuracy-related penalty under §6662(a) if the TTS position is later invalidated.
Trader Tax Status can come with substantial benefits but is also not without risk, especially for traders of crypto. A Taxpayer with TTS opens the door to deducting ordinary and necessary business expenses the average investor cannot. A Mark-to-Market election can allow a trader to shift capital gains to ordinary income, allowing a loss greater than $3000 to be reported in a single year. However, TTS is a difficult status to both achieve and prove. All of these benefits and risks must be calculated to arrive at the correct decision for each taxpayer.
This is a guest blog post written by Matt Metras, an Enrolled Agent at MDM Financial Services.