Bitcoin and other cryptocurrency loan tax risks

Is a loan "income" for tax purposes? Of course not, since you have to pay it back. In fact, if you are a borrower, other than tax deductions for interest, you might not think about taxes. Tax rules for lenders can also be clear. Lenders generally only face taxes on the interest they receive on the loan.

Sure, there can be big tax issues when loans are forgiven. If you are relieved of the obligation to pay back a loan, that is income in the amount of the debt forgiven. Mostly, though, loans can be neutral from a tax viewpoint.

How about loans in bitcoin or other digital currency? You might think the tax rules should be the same, but that's not so clear. After all, with loans in dollars, money is fungible. When you receive a loan in cash, the lender usually knows that you will invest or spend the money. Everyone understands that you will pay the lender back with other money.

But the same is not necessarily true with a loan of property. If you rent or borrow a lawn mower, can you return a different mower? If you lend your car to another person, you probably want your same car back. If the borrower returns a different car, that transaction could be viewed as the sale of the original vehicle, rather than a loan of the vehicle for tax purposes.

And you can figure that if you do end up with a different car, the IRS might say that was a sale of the car, followed by the purchase of another car. The IRS likes finding more chances to tax something! That can mean gain or loss, even if the deal ends up netting you a different car with the same value.

Remember, except for certain special tax provisions such as Section 1031 exchanges that allow tax-free swaps of property under certain conditions, just about everything you trade is taxed. Also remember, the IRS in 2014 issued a notice saying that digital currency like bitcoin is property, not currency. Most property is not fungible for tax purposes.

In general, if you want to avoid taxes, a loan of property should require the return of the same property. With loans of cryptocurrency, though, the parties probably intend the cryptocurrency lent to be treated as fungible currency, rather than like property. Whatever the IRS says, people generally view it as money.

For example, a borrower may receive bitcoins and then sell them. He may repay the lender with different, newly acquired bitcoins. The bitcoins are intended to operate as fungible currency, so that the repaid bitcoins are considered a continuation of the bitcoins that were lent (with the same tax basis and the same acquisition date). But will the IRS agree?

No one seems to know the answer to this question. And despite the parties' intentions, the IRS may not agree that this is just a loan. Think about the fluctuating value of cryptocurrency, and these tax issues could be big. In light of the IRS's conclusion that cryptocurrencies are property, there is a risk that the IRS will view bitcoins received in repayment of a loan as different bitcoins than the bitcoins lent.

Thus, there is a risk the IRS may treat the loan as a sale of the original bitcoins for tax purposes. Moreover, even if the IRS agrees that loan treatment is appropriate, it is not entirely clear how interest payments will be treated. In the current climate of uncertainty, careful documentation might help.

Emphasize in any documents that the transaction is intended to be a loan, not a sale or disposition. You could also document clearly that both parties will report the loan in this manner for tax and accounting purposes. If the transaction has any profit sharing or equity provisions, that could complicate the argument for loan treatment as well.

Another concern is fungibility. The IRS may argue that cryptocurrency is property and is non-fungible. Therefore, the loan documentation could emphasize that repayment should be made in digital currency that is identical in value and denomination (i.e., bitcoins for bitcoins, Ripples for Ripples, etc.) to the digital currency that was lent.

Perhaps the document could even require that repayment be made with the exact same cryptocurrency lent. In practice, this may not be possible, of course. Still, a requirement that the loan repayments be made from the same wallet to which it was lent (and ideally one that is segregated from other funds) might help to strengthen the argument that the very same property has been repaid.

It isn't clear what is the best strategy to avoid IRS problems. For example, the parties may want to emphasize in the loan documentation that the cryptocurrency is a fungible asset. Perhaps they want to state that the cryptocurrency received in repayment will be considered identical to the cryptocurrency lent (that will use the same acquisition date and tax basis). Loan documentation could distinguish between transfers made in repayment of the loan principal, and transfers that are payments of interest.

The IRS may have a stronger hand to argue against loan treatment if the transaction history is muddled, such as where it is not clear which payments are for interest and which are for principal. The loan documentation could spell this out, noting how payments will be made and recorded. But implementation is also key, and making sure that principal and interest payments are made according to the procedures in the loan documentation is crucial.

Care might also be taken to address possible forks in the cryptocurrency. A loan transaction that began with bitcoin might become even more problematic when the lent funds are now represented by both bitcoin and bitcoin cash. Parties should anticipate what to do in these circumstances, and consider how to emphasize in the loan documentation that repayment is still being made from the same source and property.

Taking steps of this sort may not prevent the IRS from successfully challenging the intended loan structure. Even so, it may help put you in a better position in case the loans are examined. The IRS is seeking to track profits in this new space. The IRS is using some tracking software, and is issuing summonses to cryptocurrency exchanges for user personal information and transaction histories.

Perhaps that is no wonder. After all, the IRS suggests that nationally, only 802 people reported bitcoin on their tax returns for 2015. Particularly with meteoric rises in value, and high demand, maybe some people are not reporting? The IRS sure thinks so.