Whether you view cryptocurrency as an investment, a commodity, an alternative banking system, or a form of legalized gambling, the rapid adoption and amazing recent volatility of cryptocurrencies has resulted in rapid trading with investors. As a result of the COVID-19 disruption, economic uncertainty, and PayPal’s entry into the crypto consumer market (which enables more than 300 million users to easily purchase cryptocurrencies) the crypto market has seen a dramatic surge in the values of Bitcoin and many other company lists other cryptocurrencies.
Speculative crypto trading (as well as day trading in stocks) has made many crypto investors rich on paper. Their trading resulted in significant short-term capital gains. The IRS has made it clear that Bitcoin and other cryptocurrencies should be treated as assets or intangible property – rather than currency – as it is not issued by a central bank. This leads to tax liability practically every time crypto is transferred or liquidated.
Hence, your clients’ profits from crypto investments held for less than 366 days are considered short-term. This means they will be taxed at normal income rates of up to 37 percent at the federal maximum rate (for taxable incomes greater than $ 622,051 for married taxpayers and $ 518,401 for single persons and heads of household) plus 3.8 percent net investment income tax or NIIT (for taxpayers with a modified adjusted gross income greater than $ 250,000 if they are married and file together, or $ 200,000 for single persons and heads of household), or 40.8 percent. Today, even marginally successful crypto investors and day traders often meet these high tax revenue thresholds.
A California taxpayer with taxable income greater than $ 1 million would pay an additional 13.3 percent of state tax for a staggering combined tax rate of 54.1 percent. New York taxpayers won’t be much better off as Governor Andrew Cuomo signaled that the Empire State will increase state income taxes due to COVID-induced budgetary constraints. Many other states are expected to follow suit.
Even if the cryptocurrency is held long enough to qualify for long-term capital gains rates (one year and one day), the federal tax rate is still up to 23.8 percent (20 percent LTCG tax rate plus 3.8 percent NIIT) . plus the state capital gains tax.
This is the first tax season for a lot of crypto investors and all of a sudden they don’t feel so secure and flush anymore. Given the US’s historically high federal spending in response to the COVID-19 pandemic, this tax burden is likely to increase. President Biden may propose taxing both long-term and short-term capital gains for high-income taxpayers at federal tax rates of up to 43.4 percent.
Where can investors with significant short-term profits turn to avoid or at least mitigate the possible combined tax rate of more than 50 percent?
Enter opportunity zones
The Federal Opportunity Zone (OZ) program described in IRC Section 1400Z-2 offers great potential in tax savings – including profits from cryptocurrency betting – to taxpayers who have made capital gains on October 5, 2019 or later.
Taxpayers who have achieved such gains individually in 2020 (including 2019 gains recorded on or after October 5, 2019) can invest and have those gains in a qualifying opportunity fund (QOF) until March 31, 2021 still entitled to favorable tax treatment. In addition, profits recorded in a partnership, S company or non-grantor trust in 2019 or 2020 can still be invested in a QOF on September 10, 2021. See IRS Notice 2021-10 for COVID-19 extensions.
3 Ways The OZ Program Is Bringing Short Term Profits To Investors
A timely and successful QOF investment offers taxpayers three advantages:
1. Capital gains that are timely invested in a QOF within 180 days will be deferred until the later date: (i) the time the funds are withdrawn or otherwise triggered under the “Inclusion Event” rules, or (ii ) December 31, 2026.
2. After at least five years of participation in the QOF, the taxpayer’s base in the QOF increases by 10 percent of the amount originally invested, so that the reportable profit drops to 90 percent when recorded.
3. Taxpayers who hold the QOF investment for at least ten years can exclude 100 percent of the post-reinvestment increase in value in the QOF and in the underlying assets held by the QOF – including any eligible Qualifying Opportunity Zone (QOZB) deals in which the QOF invests.
As an illustration, let’s say a New York-based crypto investor bought 100 bitcoin for $ 660,000 on April 1, 2020. For example, let’s say she sold all 100 coins for $ 2,880,000 on December 31, 2020, resulting in a short-term capital gain of $ 2,220,000. For example, suppose the taxpayer is single and has other net taxable income of $ 600,000. That is, it is subject to income tax at the highest marginal tax rates in the federal and New York City.
Federal income tax on this gain would be $ 905,760 (37 percent on short-term capital gains and 3.8 percent for the NIIT at a combined effective tax rate of 40.8 percent), and New York income tax would be $ 195,804 (8.82 percent tax rate) amount). This results in a combined tax liability of $ 1,101,564, or 49.62 percent.
If the taxpayer reinvested all or part of these short-term gains in a QOF within 180 days of December 31 (June 28, 2021) under the OZ regulations, the profit will be deferred. However, due to the ongoing impact of COVID, the sale of a directly held asset (versus the reported K-1) between October 5, 2019 and July 5, 2020 would fall under the extended reinvestment period periods under IRS Notice 2020-39 and 2021-10 . This enables an additional QOF funding period until at least March 31, 2021. Investors with K-1 profits from the 2020 calendar must be reinvested by September 10, 2021 (as the 180-day period begins on March 15, 2021). Taxpayers who timely reinvest these profits in a QOF and follow the other requirements for reinvesting in OZ can defer federal (and most state) taxes until December 31, 2026.
Since the QOF investment will be held for more than five years at this point, only 90 percent of the profit is reportable. Holding the QOF or the underlying QOF assets for a period of 10 years or more will result in a complete tax-exempt treatment of the increase in value following reinvestment of the QOF or assets held by the QOF for any federal or state purpose other than California, Mississippi , North Carolina and Massachusetts. Residents of these states do not receive the initial deferral and subsequent top-up benefits of the OZ program for government purposes. In addition, investments in property, plant and equipment in these states generally lead to a tax liability on exiting these systems – even if they are located outside of these states.
Assuming tax rates remain stable through the end of 2026, that translates to a tax saving of $ 110,156 (49.62 percent x $ 222,000 excluded profit) and allows the taxpayer to use the remaining deferred tax liability of $ 981,408 ($ 1,101,564) interest-free – $ 110,156). for a period of almost six years.
For taxpayers with patience, the OZ tax program allows asset class diversification, heavy tax deferral and ultimately avoidance of taxes on any appreciation in value after reinvestment from the date of investment to the date the QOF asset is liquidated or sold in the Between 10 and almost 30 years (the investment incentive ends on December 31, 2047).
Although a small number of states have opposed introducing tax breaks for the OZ, the vast majority of states follow the provisions of the federal OZ, and some states even offer additional incentives for OZ investors.
Cryptocurrency has gained popularity because it offers brave investors impressive flexibility and an alternative investment strategy. The “Land of OZ” may be the next frontier for crypto investors and others seeking short-term market gains, and the ultimate tax tool for maximizing the after-tax economic return on those cryptocurrency gains in 2020. You are likely to see more and more of your forward-thinking customers who are interested in crypto and OZ. If you haven’t already done so, find out more about tax treatment in cryptocurrency and the investment rules for opportunity zones.
The authors would like to thank Gerald J. Reihsen III, Esq., For his contributions to the article. You can find other helpful resources at HCVT and Joseph Darby Law.