Virtual currency, such as Bitcoin and other cryptocurrencies, is a relatively modern asset class with unique characteristics that present novel tax issues and potentially unfavorable tax consequences. On the other side of the Bitcoin, however, these characteristics can also present unique estate planning opportunities. This article will highlight several distinguishing features of Bitcoin, and explain how these features can be leveraged under current tax law to maximize wealth transfer planning opportunities.
As brief background, cryptocurrencies represent a digital form of currency with no physical counterpart. Bitcoin, the most well-known cryptocurrency, has an equivalent value in "real" currency and can be digitally traded between users or converted into legal tender. The technology underlying Bitcoin, known as blockchain, allows financial transactions to be verified and recorded through a public network of participants rather than through authentication from a central banking authority. While the decentralization of information may have its benefits, the lack of government oversight or regulation may be one factor in Bitcoin's extreme volatility. In 2011, when Bitcoin was still considered to be in its early days, the price plummeted 94% in about five months, from $32 down to $2, taking almost two years to regain those losses. In 2017, the value of one Bitcoin grew from $998 to $14,156, famously producing an investment return of 1,318%. The volatility continued, with an 85% decline over 2018, ending the year around $3,200. 2019 has seen robust gains, and is still climbing. As of the date of this article, the price is around $8,000. There are myriad other factors that may contribute to Bitcoin's wild volatility (and which are beyond the scope of this article). But we know that, at least for the foreseeable future, such volatility is a mainstay feature of Bitcoin. Understanding this volatility is critical in order to avoid any tax surprises and, in some cases, can even be used to leverage gift and estate planning opportunities.
Bitcoin as Property
The Internal Revenue Service (IRS) has declared that for federal tax purposes, virtual currency is not treated as currency at all; rather, it is characterized as property and taxed according to the general tax principles applicable to property transactions. Like other capital assets, taxpayers acquire a cost basis when investing in Bitcoin, and the sale or exchange (e.g., as payment for goods or services) of Bitcoin will generate capital gains or losses. If the Bitcoin that was sold or exchanged was held for less than one year, any capital gain is short term capital gain and taxable at ordinary income tax rates. For example, assume you purchased a single Bitcoin in 2018 when the price was $3,200 and decided to purchase a new sofa with that Bitcoin today when the trading price is $8,000. For income tax purposes, you would be taxed as though you first sold the Bitcoin and then used the sale proceeds to purchase the sofa, realizing $4,800 of short-term capital gain, subject to federal income tax at rates imposed up to 37% and potential state tax rates up to 13.3% (California).
Planning with Volatile Property
Generally speaking, the goal of any good estate plan is to transfer appreciating assets out of the estate so that the asset themselves—as well as all future appreciation—are outside the transfer tax system. Is Bitcoin an appropriate asset from this perspective? The volatility poses a potential opportunity if the value skyrockets again in the future. Granted, it also poses a potential risk that the value could plummet, meaning exemption has been wasted. To hedge this risk, one might consider utilizing a Grantor Retained Annuity Trust (GRAT), which is a wealth transfer strategy in which you transfer assets to the GRAT and retain the right to receive annual annuity payments equal to the present value of the assets transferred, plus an assumed rate of return set by the IRS (currently 2.8%). At the end of the term, any assets remaining in the GRAT pass to the remainder beneficiaries free of gift tax. In other words, if the contributed assets appreciate more than the assumed rate of return over the GRAT term, that amount passes to the beneficiaries free of tax; if the assets fail to appreciate by the assumed rate of return (or if they depreciate), then the GRAT simply terminates and returns the assets to you. Furthermore, if Bitcoin's value spikes during the GRAT term, Bitcoin can be "swapped" out of the GRAT in exchange for cash or other stable assets of equivalent value, thereby locking in the gains and ensuring the GRAT's success.
As discussed above, treating Bitcoin as property rather than currency can produce unfavorable income tax results. From an estate planning perspective, however, this characterization presents unique estate planning opportunities due to the way property is valued for tax purposes. Since transactions using virtual currency must be reported in US dollars, the IRS has instructed taxpayers to perform an exchange rate conversion "in a reasonable manner that is consistently applied." For gift tax purposes, the value of property traded on a public exchange (e.g., stock) is the average of the high and low quoted trading prices on the transfer date. Similar to public equities and other marketable securities, Bitcoin and many other cryptocurrencies are openly traded on public exchanges. It would therefore be reasonable to apply the same method used to value stocks to determine the fair market value of Bitcoin and other publicly traded cryptocurrencies. Given the big swings in trading prices throughout the day, this valuation approach could be leveraged to transfer the difference between the gift tax value and the actual Bitcoin price free of gift tax. For example, on April 2, 2019, trading prices for Bitcoin ranged between $4,147.70 and $5,104.42, yielding an average trading price of $4,626.06 for the day. For gift tax reporting purposes, the value of any gift of Bitcoin made on that day would be $4,626.06. Thus, if you transferred a Bitcoin to your child on April 2 at the moment when the price was $5,000, you would have transferred $373.94 free and clear of gift tax.
Until the IRS issues further guidance concerning virtual currency taxation, understanding how the tax principles governing property transactions apply to the unique characteristics of this modern asset class is crucial not only to avoid unfavorable income tax treatment, but also to identify potential wealth transfer opportunities. If you would like to learn more about tax and estate planning with your cryptocurrency investment, please contact a member of the Private Client Services group at Arnold & Porter.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.