Taxes could pop the crypto bubble

I’ve been following the crypto space for a few years now, mostly as a trader. Through multiple spikes, the question I hear more than anything else is, how do you call the top of the bubble? I’m a long-term optimist on the space, but we’re seeing the biggest decoupling between price and fundamental value since the dot-com bubble. That said, there’s an old trading adage that the market can remain irrational longer than you can remain solvent, and I would never bet against the HODL mob for fundamental reasons. However, I believe the currency crash could continue to bring the price of bitcoin below $1,000 USD, and the reason is purely technical: in order to pay 2017 taxes on capital gains, there will be a massive wave of selling that could cause a complete collapse in the market.

There is a large population of people who owe capital gains taxes on crypto assets, but haven’t prepared to pay them because they either don’t realize what they owe, or are willfully ignoring the issue. Citi believes that $10bn was put into Crypto in 2017, and Morgan Stanley estimates $2bn was put into crypto hedge funds, leaving $8bn to a population of retail investors that may not understand the consequences of their trading. Most importantly, I think there’s a broad assumption that you only owe taxes when you realize fiat currency gains. In fact, any time you trade one crypto asset for another, you have marked your position in the eyes of the government, and owe taxes on the gains from your original investment to the current valuation of your position. Some believe this may not be the case because of rules around ‘like kind exchange’, but literally every tax professional I’ve heard from on the subject agrees that this does not apply to crypto assets.

If participants want to be square with the IRS (which they should!), there will be more selling purely to pay taxes than the total amount of fiat currency that has been put into the entire crypto market. The market is too opaque to get global specifics on these numbers, but South Korea has forced declarations showing $1.99bn USD worth of purchases from 2014–2017, and I estimate that there will be $2.35bn USD worth of taxes owed in 2017. It doesn’t matter that the market is down over 50% from the highs, 2017 capital gains taxes are owed based on each position’s value at the time of its last transaction in 2017.

The market cannot handle real selling of this magnitude. The crypto bubble has been driven by a mob of speculators, and every time real selling has hit the market we’ve seen massive drops as buyers disappear. Even during those drops, most of the community has still just been playing with variations on massive profits. A true crash, combined with fiat currency taxes due, will cause a realization of losses that has the potential to cause a run on the market through panic selling.

The only way this doesn’t happen is if there is mass tax evasion, and the IRS has made it clear that it is coming to collect. They have hired teams to crawl immutable blockchain ledgers, and are forcing major exchanges to disclose the details of noteworthy accounts. Even plans to escape to Puerto Rico when withdrawing cash are delusional, since taxes are owed for the year when transactions are made. Once fiat currency hits real bank accounts, the IRS has a strong interest in figuring out exactly how it got there.

I’ve been worried about this for a few months now, and in my experience trying to settle up has been incredibly difficult. I genuinely don’t know what will happen if there is a run on the bank across multiple exchanges. If you’ve been lucky enough to have been exposed to crypto for the past few years, I think now is the time to settle up with the government, so that you can be ready for when blockchain really changes the world.

Like-Kind doesn’t apply, and you probably owe taxes

The key concept is that the moment you exchange one crypto asset for another, you have marked your position in the eyes of the government and owe capital gains on your profits. A common misconception is that as long as you’re converting one crypto asset for another, it could be assumed to fall under the rules of ‘like kind exchange’ and so taxes aren’t due until you actually cash out. While articles like this one from Bloomberg in December maintain that it’s a gray area, this is patently false based on every informed opinion I’ve heard.

First, IRS notice 2014–21 is pretty clear on the subject,

Q-6: Does a taxpayer have gain or loss upon an exchange of virtual currency for other property?
A-6: Yes. (Explanation follows)

The trading of crypto assets is defined as a barter transaction by the IRS, and the tax laws around those types of transactions are clear: any transaction is a taxable event, and you owe taxes on the capital gains from your original investment to its value at the time of the transaction. This UnChained podcast with tax attorney Tyson Cross and CPA Jason Tyra dives deep into these mechanics, and is summarized nicely in this presentation from Alice Townes where she’s joined by CPA John Noriega. Additionally, CPA Robert A. Green wrote this Forbes Article diving deep into the mechanics of coin-to-coin transactions, and how taxes are owed on airdrops and hard forks.

Although somebody who never transacted wouldn’t owe taxes, I believe that a significant percentage of the total crypto market cap has executed taxable events. 25% of the crypto market is held in altcoins outside of the top 5, and as new assets they very likely had taxable transactions in 2017. The most vocal HODL advocates are also the most active with research and trading. From my experience, HODL mostly means maintaining exposure to some sort of crypto asset through dips, not a particular loyalty to blind holding of bitcoin.

Let me provide an example trade scenario,
* January 1st, 2016: With USD/BTC=$500, purchase 20 BTC for $10,000
* December 25th, 2017: With USD/BTC=$15,000, convert 20 BTC to 300 ETH
* On 2017 taxes, this position marks at $300,000 of value.
* From an initial value of $10,000, long-term capital gains are owed on $290,000 of profit.
* February 1st, 2018: Sell 200 ETH for $200,000 USD

This is a best-case scenario, where the holding period was long enough that it’s clearly long-term capital gains. If you instead executed a conversion within that 12-month period, you will be taxed on your profits as if it’s income, which will probably be higher given the amounts we’re dealing with. Let’s say conservatively you owe 20% in capital gains tax to the US federal government (CA residents owe 11% state tax on capital gains on top of that!). Suddenly there is 20% * $290,000 = $58,000 of USD owed to the federal government for 2017 taxes, when only $10,000 of USD was put to work to begin with.

Paying taxes will represent more selling than crypto has ever seen

I’ll assume for a moment that everybody is actively planning to analyze their transactions and pay the taxes they owe on time (we’ll revisit this later). The incredible growth of 2017 has caused a situation where there are more taxes due for 2017 than all of the fiat currency that has ever been used to purchase crypto assets.

I’ll illustrate this using an example of declared deposit numbers from South Korea. I’ve prepared a spreadsheet where I noted the annual deposit numbers, and estimated the taxes due for each year on those deposits based on the increase in the price of Bitcoin. I tried to be conservative with my assumptions, but my numbers show that from the $1.99bn USD worth of investment from South Korea since 2014, there should be over $2.35bn USD worth of taxes due in 2017. These are rough estimates, with 3 important assumptions to name a few,

1) All of the cash is actually marking for taxes,
2) New money for a year would get 25% of that year’s capital gains, and
3) Gains were only made in BTC, even though ETH outperformed BTC by over 6x in 2017, and XRP outperformed BTC by over 25x in 2017, to name a few!

$2.35bn USD of selling by South Korea alone would be a lot. I haven’t been able to find precise numbers on the amount of crypto holdings by country, but Matthew Wong, a Senior Research Analyst at CB Insights, prepared this deck with the chart below indicating that North America has been leading the charge. Assuming that these numbers are comparable to holdings, I think it’s conservative to guess that there is another $7bn in taxes that needs to be paid by the US investors alone.

The market cannot handle the selling that will come

Crypto markets cannot handle billions of dollars of real selling. I think in fact that a lot of smart money did sell in early 2018 to prepare for taxes, and that was a factor in the 50% drop in the market from the highs. It seems like every major news story causes a 10–20% drop across all asset classes, and there have been a few: the SEC CryptoCurrency Probe, the concerns about Tether (NY Times on concerns, BitMex addressing concerns), and even just Mt. Gox liquidating an old position.

These moves still haven’t really hurt the pocket books of most crypto traders, because the gains of 2017 were so great that many people are just playing with profits. From a trading perspective, if you’ve made 30x on an investment (like our example trade scenario earlier), you’re mostly playing with house money, and on the surface can afford to be patient through dips. Crypto is notorious for the HODL mentality, and laughs at traders with ‘weak hands’.

The problem is that people will be in trouble if there is a real crash, due to forced selling related to taxes or any other reason. Already, we’re down at BTC ~$8,500, down 55% from the ~$19,000 high, and down 45% from the $15,000 2017 close. If our example trade scenario hadn’t exited in February, a current exit would be worth $110,000 (1 ETH ~= $550 USD), while the same $58,000 would still be due in taxes. If ETH goes to $250, suddenly an exit would be worth $50,000 while $58,000 is still due in taxes for 2017!

That is a very scary scenario to me, one that I was worried about personally, and that I think could contribute to even more panic selling.

There only two certainties in life: death and taxes

Let’s address the big assumption earlier, that everybody would actually try to pay the taxes owed. Bitcoin was originally designed in the aftermath of the financial crisis, to be an alternative to fiat currency. Aaron Presser wrote an article describing Japan’s bizarre monetary situation, and decentralized Bitcoin promised to be immune to manipulation. As a result, quite a few anarchists have been attracted to crypto currencies, like the Porcupine Freedom Festival in New Hampshire. Tim Swanson of ofnumbers.com provided a well-informed bearish point of view on a Fintech SV panel on crypto investing, but on taxes it was clear that he didn’t think the community would even try to pay taxes.

I actually agree, I think there are a lot of people out there who are trying to convince themselves that they don’t owe taxes for one reason or another. The problem is, even if you think you can avoid identification today, someday in the future you will need to withdraw your cash to a bank account that the government monitors. Once that happens, you will show up on the most simple IRS radars, and you will need to explain how that money got there. When you finally decide to own up to the government, your choices will be to declare the gains from previous years and pay back taxes penalties (with interest!), or lie to the IRS and say that it was all earned in the year you declared. That’s still going to be the case even if you really move to Puerto Rico in the year you cash out.

The IRS is good at their job, and there’s so much money at stake here that they are going to put resources into getting as much money as they can. First, there was the announcement that the IRS is forcing Coinbase to disclose information for all accounts with transactions over $20k. Then, they announced that they have formed teams of experts to track down crypto traders. My bet is that 2017 is the year they start hunting aggressively, and when the IRS starts hunting, they are very good at catching their prey; just ask Wesley Snipes.

Worst yet, we’re talking about an asset class defined by an immutable ledger of every transaction! This is the perfect place for an organization like the IRS (or FBI, NSA) to employ technology to have perfect visibility into who is behind every trade. I’ve heard people say that they’re holding their crypto in foreign accounts that can’t be traced by the IRS. Unfortunately that just means that you have a foreign holding that needs to be declared, in addition to the taxes you owe.

I can’t comment as to what percentage of crypto traders plan to pay taxes, but I can say that I would never want to be on the wrong side of the IRS for this activity.

Exit Strategies are difficult in the Wild West

One of the major challenges of trading crypto assets is managing the various immature exchanges to remain truly liquid. Let’s use Kraken as an example, and I’ll start by saying that I am a big fan of Kraken, they are on the bleeding edge of this space. That said, even after Kraken’s recent simplification of their limit tiers, our example investor may find himself in trouble if he hadn’t planned for his taxes accordingly. If our investor started off with Kraken’s ‘Low’ limits, then the max that could be withdrawn in a given month is $50,000 USD — less than the actual $58,000 owed in taxes! This could cause the selling of other assets just to be able to pay that tax bill in time.

You cannot even assume that the investor will successfully be able to withdraw all $50,000 from Kraken even when limits are respected. Of 19 attempts I made to withdraw fiat from Kraken in January, only 3 were successful! My expectation right now is that crypto trading is the wild west, and you shouldn’t be surprised if an entire exchange goes down like Mt. Gox, $500mm of currency disappears from an exchange like Coincheck, or ghost transactions occur even on an exchange as reliable as Coinbase (even if it was Visa and Worldpay’s fault!). Until fiat cash is in an FDIC insured fiat bank account, I consider it funny money.

The thing that I worry most about, is that exchanges aren’t actually prepared for a run-on-the-bank style situation. That includes both major exchanges like Kraken, and especially the newer exchanges with most altcoins. If people genuinely try to settle up with the government, we’re in for some rocky times.

Be careful; I’m hoping for the best!

The only solace I can provide is that the IRS is not trying to ruin investors, they just want everybody to be making a best effort to follow the rules. One of the best things about hiring a CPA is that you will be telling the IRS that you have reviewed your situation with a professional, and are making best effort assumptions given the available guidance. Now is the time to file for an extension if you’re not ready, and start putting in place a paper trail to protect yourself. If you have clearly made a best effort, the odds that you are charged criminally seem to be close to zero. Even if exchanges actually go down before you get your money out, you can claim that the funds were not “reasonably retrievable” as an excuse.

I’m fortunate to have been a part of this space for the past few years, and I’m excited to dig in even deeper with a group of really smart people who are trying to change the world. I want this community to succeed, but unfortunately I’m worried that a lack of caution regarding taxes could ruin some people. My only position left in crypto is bearish in case the market heads even lower than it is now. Like I said earlier, I think BTC/USD under $1000 is very possible. Even that would only bring us back to March 2017 levels, which is incredible considering the fact that Bitcoin isn’t actually that useful as a currency!

Most importantly though, I hope people lock in the win by putting real cash in bank accounts and being squeaky clean about paying taxes. That way, if the blood bath happens, those who built this market will be in a position to keep it going into the next epoch of the space. The future is bright, let’s all survive to be a part of it, I’m hoping for the best!

Quick disclaimer, I am not an investment advisor, nor a tax professional. All information in this article should be considered informational and not a recommendation to buy or sell anything.