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TAX CLINIC

United States, then the capital gains is whether ordinary losses recognized
As cryptoassets that flow through to a non-U.S. investor under the mark-to-market rules may be
challenged and recharacterized to short-
would be subject to withholding taxes as
evolve, resulting effectively connected income (ECI). term capital losses.
4. Do the wash-sale rules under
in more complex Because the IRS has not elaborated Sec. 1091 apply to cryptoassets?:
transactions, the on the “property” tax classification, it is Sec. 1091 disallows a deduction under
unclear if the trading safe harbor applies
lack of guidance to cryptoassets. Furthermore, cryptoasset Sec. 165 for a loss sustained from any
for private fund trading may occur across both central- sale or other disposition of shares of
stock or securities where it appears that,
ized and decentralized (unregulated
managers has left a “DEX” or decentralized exchange) within a period beginning 30 days before
void that tax planning platforms. Therefore, if cryptoassets are the date of such sale or disposition
considered commodities, the trading
and ending 30 days after such date,
professionals attempt safe harbor still may not apply due to the taxpayer has acquired substantially
to mitigate through the limitation to only commodities that identical stock or securities (“wash-sale
taking reasonable are of a kind customarily traded on an rule”). The wash-sale rule is intended
organized commodity exchange.
to prevent loss harvesting where the
positions based on In 2017, the CFTC stated in a taxpayer’s economic position does not
the legislative intent. Customer Advisory that bitcoin is a change.
commodity. Additionally, both the Chi-
Applying the wash-sale rules to all
cago Mercantile Exchange (CME) and cryptoasset transactions may be outside
an argument that cryptoassets are not the Chicago Board Options Exchange of the original intent of Sec. 1091.
considered “readily marketable stocks (CBOE) Futures Exchange (CFE), To see why, consider that many DEX
and securities.” However, taking this which are CFTC-regulated exchanges, platforms require an exchange to the
position creates risk of underpayment of allow for trading bitcoin and ether native token to access the platform (e.g.,
tax for certain investors. For example, if futures products. Based on the futures Uniswap, 1inch Exchange). The na-
the investment company rules do apply, markets, there may be an argument that tive token generally also has a trading
private fund managers need to be aware cryptoasset private funds that trade in market. If the private fund manager is
of the application of the Sec. 721(b) bitcoin or ether are reasonably within actively trading in and out of a DEX
diversification rule and Sec. 707(a)(2)(B) the trading safe harbor. that requires this type of exchange, any
disguised-sale rules when determining 3. Are cryptoasset trading funds loss from these routine transfers would
whether to receive or to distribute eligible for the mark-to-market theoretically be disallowed if wash-sale
cryptoassets in-kind. election under Sec. 475(f)?: Sec. rules are in force.
2. Are cryptoasset trading funds 475(f) allows an election for traders in If cryptoassets are not considered
eligible for the Sec. 864 exclusion securities or commodities to recognize securities, then the wash-sale rules
from U.S. trade or business gain or loss at the close of each tax year should not apply to this situation
treatment?: Traditional private as if the securities or commodities were or disallow loss harvesting. But the
funds that regularly trade securities, sold on the last business day for their full Biden administration’s proposed Build
or commodities that are of a kind fair market value. This election allows Back Better Act would have expanded
customarily traded on an organized private fund managers who trade assets the application of wash-sale rules to
commodity exchange, generally rely on held for less than 12 months in large explicitly cover cryptoassets (as defined
Sec. 864(b)(2) to prevent their fund’s volumes to recognize ordinary income within the act) and commodities as well
activities from being treated as engaged and loss. Ordinary treatment relieves as securities. As of this writing, it does
in a U.S. trade or business. This allows private fund managers from the capital not appear that the Build Back Better
the capital gain that is allocable to non- loss limitations that may have been a Act or this specific provision is going
U.S. investors to escape withholding, burden to their investors. to be passed into law.
which would reduce the non-U.S. If a private fund manager makes 5. Are “proof of stake” validating
investors’ returns on their investment the election under Sec. 475(f) and it is rewards considered U.S. trade
in the fund. If this “trading safe harbor” later determined that cryptoassets are or business income?: The current
did not apply and such private funds not considered either a commodity or leading consensus mechanism for
trading activity is conducted within the security for this purpose, the general risk blockchain networks is “proof of stake”

22 August 2022 The Tax Adviser