Authors: Mark Leeds and Brennan Young, Mayer Brown
The statements in this document reflect guidance issued as of March 23, 2020.
This White Paper is presented for general information only. It may not be relied upon as legal or tax advice. Interested persons should contact their own tax advisors with respect as to how the matters covered herein apply to their own situations.
An investor may want to lock-in gains on an appreciated position in cryptocurrency while remaining invested in the property. One way to accomplish this is through a “short-against-the-box” transaction. In a “short-against-the-box” transaction,1 an investor with an appreciated cryptocurrency position, borrows an equivalent amount of the cryptocurrency from an exchange and sells the borrowed cryptocurrency. If the cryptocurrency falls in value, the short-seller keeps the proceeds from the original sale of the borrowed assets and repays the loan with depreciated value cryptocurrency that had been held inside the “box.” In exchange for this downside protection, the short-seller effectively gives up the ability to benefit from any appreciation in the cryptocurrency held inside the “box.”
Historically, taxpayers took the position that the short-against-the-box transaction with respect to stock did not trigger gain in the hedged position for federal income tax purposes. Concomitantly, gain or loss from the closing of the short sale was determined based on how the taxpayer settled the transaction – with cash, the shares held in the box or with newly-purchased shares. Subsequent changes to the Tax Code, including explicit short sale rules, straddle rules and constructive sale rules, severely limited the ability of taxpayers to garner these tax benefits with respect to transactions in stock. This White Paper discusses certain U.S. federal tax rules applicable to a short-against-the-box sales of cryptocurrency.
Code § 12592– Constructive Sale?
Under Code § 1259, if a taxpayer enters into a “constructive sale” of an “appreciated financial position,” the taxpayer will generally recognize the inherent gain at the time of the constructive sale (unless a statutory exception applies) for federal income tax purposes. A “constructive sale” includes entering into one or more of the following transactions over the appreciated financial position: (1) a short sale, (2) an offsetting notional principal contract, (3) futures or forward contracts, or (4) certain similar transactions that have substantially the same effect as (1)-(3).3 An “appreciated financial position” is any position with respect to any stock, debt instrument, or partnership interest.4
The Internal Revenue Service (the “IRS”) and the Commodity Futures Trading Commission have issued rules stating that virtual currencies should be treated as commodities.5 The definition of “appreciated financial position” under Code § 1259 does not include commodities. Taxpayers generally do not treat commodities as subject to Code § 1259. Accordingly, without further IRS guidance, it may be reasonable to take the position that Code § 1259 does not trigger a constructive sale when cryptocurrency is sold short-against-the-box.
In taking this position, cryptocurrency investors should be careful to record which shares are subject to, and are used to close, the short-against-the-box transaction. The IRS’s recently updated list of frequently asked questions on cryptocurrency transactions (the “FAQs”) states that when a taxpayer owns multiple units of one kind of cryptocurrency and sells or is deemed to sell, exchange, or otherwise dispose of some units, the taxpayer is free to choose which units are deemed sold, exchanged, or otherwise disposed of, but only if a taxpayer can specifically identify which unit or units of cryptocurrency are involved in the transaction and can substantiate his tax basis in those units. The FAQs provide that the specific cryptocurrency unit can be identified for this purpose by a taxpayer if the taxpayer documents the unit’s unique digital identifier such as a private key, public key, or address, or by maintaining records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address. The documentation must show (1) the date and time each unit was acquired, (2) the taxpayer’s basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.
Tax Treatment of the Short Sale
Assuming that a short-against-the-box transaction is not treated as a constructive sale under Code § 1259, then under Code § 1233, a taxpayer will generally recognize capital gain or loss when the short position is closed out, provided that the property sold short constitutes a “capital asset” for U.S. federal income tax purposes.6 Thus, provided a cryptocurrency investor holds an appreciated financial position in cryptocurrency as a capital asset, if such investor enters into a short-against the-box transaction and closes the transaction with the appreciated units, closing out the short sale will be considered capital gain or loss potentially eligible for long-term capital gain treatment.
Long-term capital gains are gains from the disposition of property held for more than one year. Long-term capital gains are taxed at the beneficial rate of 20% to non-corporate investors. Short term capital gains are taxed at the ordinary income tax rate of 37% to non-corporate investors. Both of long-term and short-term capital gains are subject to Social Security taxes of 3.8%.
Code § 1233(b) treats gain from a short sale as short-term capital gain when a taxpayer owned “substantially identical property” at the opening of the short sale and the taxpayer’s holding period for the long position at such time was one year or less. The purpose of this rule was to prevent a taxpayer from using short-against-the-box transactions to hedge assets until the taxpayer’s holding period on such assets is at least equal to the long-term capital gain holding period. The short sale holding period rule only applies to stock, securities, and commodity futures, not actual commodities.7 Since under current IRS guidance it seems likely that cryptocurrency is a commodity, Code § 1233(b) arguably does not apply to cryptocurrency short sales.
Even if the short-against-the-box rules don’t apply to limit a taxpayer’s ability to “age” appreciated cryptocurrency that is the subject of a short sale, the straddle rules could have the same effect and with even more dire consequences. A long position in cryptocurrency and a short-against-the-box position in the same or a highly correlated cryptocurrency is likely to constitute a straddle.8 When the straddle rules apply, if the long position that is the subject of a straddle has not been held for more than one year at the time that the straddle is opened, the holding period of the long position is reset to zero.9 The straddle rules only apply to actively-traded property.10 The IRS is likely to treat Bitcoin and Ethereum as actively-traded, but traders may have a tax position with respect to less liquid cryptocurrencies that such cryptocurrencies are not actively-traded within the meaning of the straddle rules. If they were successful in this position, the straddle rules should not apply to prevent aging hedged short-term cryptocurrency positions.
1 For those that are interested, it appears the name “short-against-the-box” originated because investors would keep stock certificates in a lock-box. The investors were not selling their shares in the box, but instead, those borrowed short.
2 All “Code §” references are the to Internal Revenue Code of 1986, as amended.
3 Code § 1259(c)(1). The same rules apply if the taxpayer is initially short and enters into a constructive sale of the short position by entering into a long position under one of the enumerated transactions.
4 Code § 1259(b).
5 See https://www.govinfo.gov/content/pkg/FR-2017-12-20/pdf/2017-27421.pdf.
6 Code § 1233(a). In general, the cryptocurrency will constitute a capital asset unless the taxpayer is treated as a dealer in cryptocurrency. Most traders in cryptocurrency should not be treated as dealers. If you are unsure of your status as a trader or a dealer, please consult with your tax advisor.
7 Code § 1233(e)(2).
8 Code § 1092(c).
9 Temp. Treas. Reg. § 1.1092-2T(a).
10 Property is treated as actively-traded if there is a system of general circulation (including a computer listing disseminated to subscribing brokers, dealers, or traders) that provides a reasonable basis to determine fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of one or more identified brokers, dealers, or traders or actual prices (including rates, yields, or other pricing information) of recent transactions. Treas. Reg. § 1.1092(d)-1(b)(2)(i).