The recently released final text of the Law of Reconciliation (SEC.138151) aims to subject cryptocurrencies to a complex tax rule known as constructive sales. According to this proposed rule, which could come into effect on January 1, 2022, users of cryptocurrencies could pay taxes without selling their crypto positions.
What is a Constructive Sale?
Before talking about constructive sales, it is important to understand the standard tax rules for reporting cryptocurrency profits. Profits from cryptocurrencies are usually not taxed until realized. You realize cryptocurrency capital gains when you actually cash out or convert one coin with another.
However, a constructive sale can occur even if you are not actually trading your coins. It occurs when you have an Appreciated Financial Position (AFP) and take a “substantially identical” equalization position through an option, future, or futures contract to reduce the risk of losing money on the long position.
For example, let’s say Tom bought 1 Bitcoin (BTC) for $ 10,000 on Jan 15, 2020; On September 27, 2021, it is worth $ 50,000 so has an estimated financial condition; On this day, Tom is concerned that the price of BTC will drop below $ 50,000. This put option contract gives Tom the right to sell (or sell short) 1 BTC for $ 45,000, even if prices drop below $ 45,000.If the price of BTC rises above $ 50,000, you can still benefit from selling the long position, which is why these two opposing positions include your profits.
Taxation on Constructive Cryptocurrency Sales
Capital Gain Taxes
A constructive sale will take place as soon as Tom buys an option to short BTC on September 27, 2021. The rule requires you to pay income and taxes as if the long position had actually been sold. ? According to the tax code, you sold your position indirectly by buying an opposing position.
As a result, Tom must report a capital gain of $ 40,000 ($ 50,000 $ 10,000).
(A constructive buy is also possible if you buy a currency while holding an estimated short position in a substantially identical currency)
Cost Basis Adjustment
Tom then needs to adjust the AFP cost base by the recognized profit amount so that the updated cost base of the original BTC position is $ 50,000 ($ 10,000 + $ 40,000).
Capital Gains Clock Resets
In addition, the implied sale resets the capital gains clock on the original long position. A new hold period will begin on September 27, 2021 for BTCs purchased on January 15, 2020.
Closed Transaction Exception
Fortunately, you can get around the constructive selling rule by properly planning your transactions.
You can ignore the implied sale if all of the following conditions are true:
- You closed the short position during the tax year or at the end of the 30th day after your tax year ended.
- Maintain the estimated financial position for at least 60 days from the date the short position was closed.
- Your risk of loss was never reduced by holding certain other positions during these 60 days.
To continue with the previous example, let’s say Tom closed the short position on January 15, 2022 and closed the original long position (1 BTC bought on January 15, 2020) until at least March 15, 2022 (60 days from January) held 15, 2022). In addition, he did not initiate any further compensation positions from January 15, 2022 to March 15, 2022 in order to reduce his risk. Tom has met all three requirements here. ) in your 2021 tax return.
Ambiguity & Administrative Burden on Taxpayers
The implicit sell rule only applies if you buy an “essentially identical” offsetting position. What is “essentially identical” is not clearly defined in the tax code and depends on the circumstances of the individual case. This can lead to confusion and inaccuracies. For example, it is reasonable to assume that a long position in BTC and a shorting Wrapped Bitcoin (wBTC) would result in a constructive sale as they are essentially the same. However, whether having a long position in BTC and shorting Grayscale Bitcoin Trust (GBTC) units is a constructive sale or not is subject to interpretation.
It is your responsibility to track constructive sales, adjust the cost base, and report revenue as necessary. Cryptocurrency exchanges will not report constructive sales in their transaction history reports. Also, it is unlikely that they will see constructive sales transactions in the upcoming 1099B forms. After all, this rule, along with the wash sale rule, will add significant administrative burden to cryptocurrency taxpayers.