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Can Virtual Currency Traders Elect Into Special Rules that Allow Current Deductions for Trading Losses?

Author: Andrea S. Kramer, McDermott Will & Emery

The statements in this document reflect guidance issued as of March 19, 2020.


Traders in virtual currency might want to currently deduct trading losses and avoid application of  the capital loss limitations that apply to traders. To do so, they would want to elect into the  special tax rules found at I.R.C. § 475(f) for electing traders in securities or commodities.  Taxpayers who qualify for either of these trader elections would mark their virtual currency  trading gains and losses to market at ordinary income rates. Electing into I.R.C. § 475 means  taxpayers would receive ordinary income and loss on positions closed out during the year and on  all positions open at the end of the year. In exchange for ordinary tax treatment and for the  acceleration of tax on open positions, electing traders can report their losses without applying  capital loss limitations, the tax wash sales rule at I.R.C. § 1091, or the tax straddle rules at I.R.C.  § 1092. This Memorandum addresses the analysis that taxpayers who hold virtual currency  positions need to make to evaluate whether they are eligible for the I.R.C. § 475(f) election as a  trader in securities or a trader in commodities (collectively, trader elections). For a discussion of  the tax wash sales rule, see McDermott’s Memorandum, “When Virtual Currency Positions Are  Subject to the Wash Sales Rule.” For a discussion of the tax straddle rules, see McDermott’s Memorandum, “When Virtual Currency Positions Are Subject the Straddle Rules.” 

The trader elections depend on meeting two requirements. First, the taxpayers’ virtual currency  transactions must qualify for tax purposes as “securities” to make the securities trader election 1 or as “commodities” to make the commodities trader election.2 Second, assuming the trader’s  virtual currency transactions meet the I.R.C. § 475 definitions of “securities” or “commodities,”  the taxpayer’s trading activities must rise to the level of active trading under applicable case law. 

Virtual Currency Positions as Securities or Commodities 

To make a valid trader election, virtual currency traders must determine if the particular virtual  currency positions they trade qualify as securities or commodities. 

Securities Defined 

A “security” is broadly defined in I.R.C. § 475 to include any (1) share of stock; (2) partnership  or beneficial ownership interest in a widely held or publicly traded partnership or trust; (3) debt  interest;3 and (4) interest rate, currency, or equity “notional principal contracts” (such as swaps, caps, and floors). A security also includes at item (5) any evidence of any interest in, or any  derivative financial instrument in, any currency or security within the terms of items (1) through  (4), including options, forwards, short positions, and similar financial. And, it also includes at  item (6) a “position” that is not itself a security under items (1) through (5) but the position is a  “hedge” of such a position and it is clearly identified as a hedge with respect to that security.4   There is no requirement that the item, itself, must be “actively traded.” 

Because the items that qualify as “securities” are carefully enumerated in I.R.C. § 475(c)(2), it is  not likely that the IRS will try to treat other items as “securities” for purposes of I.R.C. § 475 just  because they are treated as securities for federal securities law purposes. It is likely that the IRS will only treat items as securities if they clearly fit into the items that are enumerated. This  means that taxpayers who enter into positions in virtual currency need to carefully consider item 5 (set out above) to see whether their positions might meet the definition of that item. For a  discussion of the tax definitions of securities, see McDermott’s Memorandum, “When Virtual  Currencies are Securities for Tax Purposes.” 

Commodities Defined 

The term “commodity” is broadly defined in I.R.C. § 475 to include any commodity that is  actively traded for purposes of the straddle rules in I.R.C. § 1092(d)(1).5 For a discussion of the  straddle rules, see McDermott’s Memorandum, “When Virtual Currency Positions are Subject to  the Straddle Rules.” Commodities include physical commodities, derivative instruments in any  commodity, and evidences of interests in any commodity. Unlike the I.R.C. § 475 statutorily enumerated definitions of a “security,” which specifically excludes section 1256 contracts, the  term commodity specifically includes section 1256 contracts, making them subject to I.R.C. § 475 rather than I.R.C. § 1256. For a discussion of I.R.C. § 1256, see McDermott’s  Memorandum, “Special Tax Rules Apply to Certain Bitcoin Futures and Options and Might  Apply to Other Virtual Currencies in the Future.” As with the definition of security, the commodity definition includes any position that is not itself a commodity if it serves as a hedge  with respect to a commodity.  

Although not free from doubt, the IRS “has historically deferred to the CFTC and its predecessor  agencies as to what constitutes a ‘commodity’ for U.S. Federal tax purposes.” 6 This makes it possible that I.R.C. § 475 will include actively-traded items that are treated as commodities  under the federal commodity laws. For a discussion of the tax definitions of commodities, see  McDermott’s Memorandum, “When Virtual Currencies are Commodities for Tax Purposes.” 

Securities or Commodities? 

Most virtual currencies, in and of themselves, are more likely to be taxed under I.R.C. § 475 as  commodities rather than as securities. With that said, there is no definitive answer one way or  the other as to whether certain virtual currency positions can be treated as securities or  commodities. There are good arguments that certain virtual currency positions are securities and that other actively-traded virtual currency positions are commodities.  

This leads us to the question of which of the two trader elections a virtual currency trader might  consider making for appropriate virtual currencies and positions in those virtual currencies.  Which virtual currency positions are securities, and which ones are commodities? This  commodity or security definitional conundrum might not ultimately matter if the IRS is willing  to allow taxpayers who believe they might fall into both categories to elect under both the  securities trader and the commodities trader provisions. Although there is no specific authority  for making such a dual election, the author is prepared to explore this possibility with the IRS in  appropriate client situations. 

Taxpayers Must be Active Traders 

If a particular virtual currency qualifies as a security or a commodity, electing traders must also  meet another requirement. Their activities must be substantial and carried on in a continuous and  regular basis. Trader tax status is a fact-based determination, subject to the taxpayer’s actual facts and circumstances.7 Traders must profit from daily market movements, not from dividends,  interest, or capital appreciation. IRS Publication 550 identifies some factors to consider,  including the length of holding periods, frequency of trades, whether the taxpayer is engaged in  the activity to produce a principal source of income, and the amount of time the taxpayer devotes to the trading activity.8

Trade or Business Expenses  

Traders’ trade or business expenses as deductible under I.R.C. §162. Deductible expenses can  include, office rental, other office expenses, salaries, computer equipment, software programs,  Internet access fees, and utilities. 

Application of Trader Elections 

Electing traders receive ordinary gain or loss for their securities and commodities positions that  are held in connection with their business of being securities or commodities traders. Because taxes are paid on recognized and unrecognized gains and losses, electing traders can be required  to pay tax on gain that, in fact, they may never actually realize. If they continue to hold contracts  that were marked-to-market at year end, gains and losses realized in a subsequent tax year are  adjusted to reflect gains and losses taken into account in the preceding taxable year. The  requirement to mark open positions to market can, therefore, distort income and cause economic  hardship if gains that were reported in the first year do not materialize in a subsequent tax year.  

In evaluating the costs of accelerating gains under the mark-to-market regime, electing traders  must also evaluate the fact they can deduct their trading losses against trading profits and their  ordinary income from other sources. Losses of electing traders are not limited to the standard  $3,000 capital losses amount. 

Elections and Revocations 

Elections into I.R.C. § 475 and revocations of elections are subject to detailed reporting and  filing requirements. Late elections or revocations are not generally allowed, except in unusual  and compelling circumstances that comply with Treasury regulations and IRS guidance. 


Taxpayers who are interested in exploring an election into I.R.C. § 475 should consult with their  tax advisors about the availability of the election and the federal and state tax implications of  making such an election. Many states do not follow federal tax returns in computing state taxes.


1 I.R.C § 475(f)(1). 

2 I.R.C § 475(f)(2). 

3 I.R.C § 475(c)(2). Although the term “security” does not include section 1256 contracts, such contracts, as defined  in I.R.C. §1256(g), can be treated as securities to the extent they qualify as hedges under item (6). For a discussion  of section 1256 contracts, see McDermott’s Memorandum, “Special Tax Rules Apply to Bitcoin Futures and  Options and Perhaps to Additional Virtual Currencies in the Future.” 

4 I.R.C § 475(c)(2)(F)(ii). 

5 I.R.C. § 475(c)(2)(A). Treas. Reg. § 1.1092(d)-1(c)(1) provides that the actively traded standard requires an  established financial market, ranging from an interdealer market to an established financial market.

6 NYBA Tax Section, “Report on the Taxation of Cryptocurrency,” January 26, 2020. See, Rev. Rul. 73-158, 1973- 1 C.B. 337 (the word “commodities is used in section 864(b)(2)(B) of the Code in its ordinary financial sense and  includes all products that are traded in and listed on commodity exchanges located in the United States.  Furthermore, the word “commodities” includes actual commodities and commodity futures contracts. 

7 The trader election will be effective only if the electing taxpayer is a trader in either securities or commodities. For  the definition of “trader” to be applied for these purposes, see Chen v. Comm’r, 87 T.C.M. (CCH) 1388 (T.C. 2004);  Arberg v. Comm’r, 94 T.C.M. (CCH) 215 (T.C. 2007); and Holsinger v. Comm’r, 96 T.C.M. (CCH) 85 (T.C. 2008).  See also, Bielfeldt v. Comm’r, 231 F.3d 1035 (7th Cir. 2000), describing the difference between a trader and a  dealer, noting that a “dealer’s income is based on the service he provides in the chain of distribution of the goods he  buys and resells, rather than on fluctuations in the market value of those goods, while the trader’s income is based  not on any service he provides but rather on, precisely fluctuations in the market value of the securities or other  assets that he transacts in.” The courts essentially apply a merchant analogy to determine whether a taxpayer sells  securities to customers. See, Bradford v. U.S., 444 F.2d 1133 (Ct. Cl. 1971) [71-2 U.S.T.C. ¶9542]. See also, Kemon v. Comm’r, 16 T.C. 1026 (1951). 

8 IRS Pub. 550. See also Paoli v. Comm’r, 54 T.C.M. (CCH) 1574, 1578 (1988); Chen v. Comm’r, 87 T.C.M.  (CCH) 1388 (2004). The phrase “trade or business” is not defined in the Code or Treasury regulations. Various  factors are considered, with no one factor dispositive. Elements of a trade or business include (1) activities that occupy “the time, attention and labor” of the taxpayer for the purpose of “a livelihood or profit”; (2) the continuity  and regularity of the taxpayer’s activities; and (3) a profit motive. In Commissioner v. Groetzinger, the Supreme  Court held that a professional gambler could be in a “trade or business” if the gambler devotes his full-time activity  to gambling and it was his intended livelihood source. In this situation, his activity should be regarded as a trade or  business “just as any other readily accepted activity.” 480 U.S. 23 (1987).

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