Whether you consider cryptocurrency an investment, a commodity, an alternative banking system or a form of legalized gambling, the rapid adoption and stunning recent volatility of cryptocurrencies has led to frenetic trading by investors. As a result of COVID-19 disruption, economic uncertainty and the entry of PayPal into the crypto-consumer market (allowing more than 300 million users to buy cryptocurrencies easily), the crypto market has seen a dramatic runup in the values of Bitcoin and many other cryptocurrencies.
Speculative crypto trading (as well as day trading of stocks) has made many crypto investors wealthy on paper. Their trading generated a substantial amount of short-term capital gains. The IRS has made it clear that Bitcoin and other cryptocurrencies should be treated as assets or intangible property — and not currency — since it is not issued by a central bank. This results in taxability virtually every time crypto is transferred or liquidated.
Thus, your clients’ gains from crypto investments that were held less than 366 days are considered short-term in nature. That means they will be taxed at ordinary income rates as high as 37 percent at the maximum federal rate (for taxable incomes in excess of $622,051 for married filing jointly taxpayers, and $518,401 for single and head of household taxpayers) , plus the 3.8 percent Net Investment Income Tax, or NIIT (for taxpayers with modified adjusted gross income in excess of $250,000 if they’re married filing jointly, or $200,000 for single and head of household), or 40.8 percent. These days, even marginally successful crypto investors and day traders are often meeting these high-tax income thresholds.
A California taxpayer with more than $1 million of taxable income would pay an additional 13.3 percent of state tax for a staggering 54.1 percent combined tax rate. New York taxpayers won’t fare much better as Governor Andrew Cuomo signaled the Empire State will raise state income taxes due to COVID-induced budget shortfalls. Many other states are expected to follow suit.
Even if the cryptocurrency is held long enough to qualify for long-term capital gains rates (a year and a day), the tax rate will still be up to 23.8 percent at the federal level (20 percent LTCG tax rate plus 3.8 percent NIIT), plus the state capital gains tax.
This is the first tax season for many crypto investors and suddenly they’re not feeling so confident and flush. With the U.S. facing historically high federal spending in response to the COVID-19 pandemic, this tax burden seems likely to increase. President Biden may propose taxing both long-termandshort-term capital gains at federal rates as high as 43.4 percent for high-income taxpayers.
Where can investors with substantial short-term gains turn to avoid, or at least mitigate, the possible 50+ percent combined tax rate they face?
Enter opportunity zones
The federal opportunity zone (OZ) program as described under IRC Section 1400Z-2 offers a large potential tax savings to taxpayers who generated capital gains on Oct. 5, 2019 or later — including gains from cryptocurrency bets.
Taxpayers who individually generated such gains in 2020 (including gains in 2019 recognized on or after Oct. 5, 2019) can invest those gains into a qualified opportunity fund (QOF) as late as until March 31, 2021 and still qualify for favorable tax treatment. Further, gains recognized in 2019 or 2020 in a partnership, S corporation or non-grantor trust can be invested in a QOF as late as Sept. 10, 2021, respectively. See IRS Notice 2021-10 for COVID-19 extensions.
3 ways the OZ program benefits investors with short-term gains
A timely and successful QOF investment provides taxpayers with the following three benefits:
1. Capital gains timely invested within 180 days into a QOF are deferred until the later of: (i) the time that the amounts are withdrawn or otherwise triggered under the “inclusion event” rules or (ii) Dec. 31, 2026.
2. After holding the QOF interest at least five years, the taxpayer’s basis in the QOF is increased by 10 percent of the original amount invested and thus the reportable gain drops to 90 percent when recognized.
3. Taxpayers holding the QOF investment for at least ten years can exclude 100 percent of the post-reinvestment appreciation in the QOF and in the underlying assets held by the QOF — including any eligible qualified opportunity zone business (QOZB) into which the QOF invests.
To illustrate, assume a crypto investor residing in New York purchased 100 Bitcoin on April 1, 2020, for $660,000. Assume she sold all 100 coins on Dec. 31, 2020, for $2,880,000, resulting in a short-term capital gain of $2,220,000. Assume the taxpayer is single and had other net taxable income of $600,000. That means she is subject to income tax at the highest federal and New York marginal income-tax rates.
The federal income tax on this gain would be $905,760 (37 percent on short-term capital gains and 3.8 percent for the NIIT, for a combined 40.8 percent effective tax rate), and the New York income tax would be $195,804 (8.82 percent tax rate). This results in a combined tax liability of $1,101,564 (49.62 percent).
Under the OZ regulations, if the taxpayer reinvests all or a portion of these short-term gains into a QOF within 180 days from Dec. 31 (June 28, 2021), then the gain will be deferred. However, due to COVID’s continuing impact, if the sale of a directly held asset (vs. K-1 reported) occurred between Oct. 5, 2019 and July 5, 2020, then the 180-day reinvestment period would fall within the extended reinvestment periods provided in IRS Notice 2020-39 and 2021-10. This allows extra QOF funding time through at least March 31, 2021. Investors with calendar 2020 K-1 gains will have until Sept. 10, 2021 to be reinvested (since the 180-day period begins on March 15, 2021). Taxpayers who timely reinvest those gains into a QOF and follow the other OZ re-investment requirements can defer federal (and most state) taxes until Dec. 31, 2026.
Since the QOF investment will have been held for more than five years on that date, only 90 percent of the gain will then be reportable. Holding the QOF or the underlying QOF assets for 10 years or more will result in complete tax-free treatment of the post-reinvestment appreciation in the QOF or assets held by the QOF for federal and state purposes other than in California, Mississippi, North Carolina and Massachusetts. Residents of these states will not obtain the initial deferral and subsequent step-up benefits of the OZ program for state purposes. In addition, any tangible property investments into these states generally will generate taxability upon exit from those investments — even if residing outside those states.
Assuming tax rates hold steady through the end of 2026, this amounts to a tax savings of $110,156 (49.62 percent x $222,000 of excluded gain) and allows the taxpayer the interest-free use of the remaining deferred tax liability of $981,408 ($1,101,564 – $110,156) for a period of almost six years.
For taxpayers with patience, the OZ tax program allows for diversification of asset investment classes, a powerful tax deferral and ultimately the avoidance of tax on all post-reinvestment appreciation from the investment date until the date the QOF investment is liquidated or sold, which can be anywhere from 10 to almost 30 years in the future (the investment incentive ends on Dec. 31, 2047).
Although a small number of states have declined to adopt the OZ tax benefits, the vast majority of states do follow the federal OZ provisions, and some states even provide additional incentives for OZ investors.
Cryptocurrency has gained favor because it offers impressive flexibility and an alternative investment strategy to bold investors. The “Land of OZ” may well be the next frontier for crypto investors and others generating short-term gains in the market, and the ultimate tax tool for maximizing the after-tax economic return on those 2020 cryptocurrency gains. You are likely to see more and more of your forward-thinking clients gravitating toward crypto and OZ. If you haven’t done so already, get up to speed on both cryptocurrency tax treatment and opportunity zone investment rules.