The recently released final text of the reconciliation bill (SEC.138151) intends to subject cryptocurrency to a complex tax rule called, constructive sales. Under this proposed rule which could go into effect on January 1, 2022, cryptocurrency users could incur taxes without even selling their crypto positions.
What is a Constructive Sale?
Before we talk about constructive sales, it’s important to understand the default tax rules for reporting cryptocurrency gains. Typically, crypto gains are not taxed until they are realized. You realize cryptocurrency capital gains when you actually cash out or convert one coin with another.
However, a constructive sale could happen even when you don’t actually trade your coins. It occurs when you have an appreciated financial position (AFP) and enter into an offsetting position of the “substantially identical” asset through an option, futures, or a forward contract to reduce the risk of losing money on the long position.
For example, say Tom purchased 1 bitcoin (BTC) for $10,000 on January 15, 2020. On September 27, 2021, it’s worth $50,000 so he has an appreciated financial position. On this date, Tom is worried about the BTC price falling below $50,000. To reduce the risk of losing money, he purchases a put option to sell BTC at $45,000. This put option contract gives Tom the right to sell (or short) 1 BTC at $45,000 even if the prices fall below $45,000. If the BTC price rises above $50,000 he can still profit from selling the long position. Thus, these two offsetting positions locks in his gains.
Taxation on Constructive Cryptocurrency Sales
Capital Gain Taxes
A constructive sale occurs as soon as Tom purchases an option to short BTC on September 27, 2021. The rule requires you to report income and pay taxes as if the long position was actually sold. Why? According to the tax code, you have indirectly sold your position by buying an offsetting position.
As a result, Tom has to report a capital gain of $40,000 ($50,000 – $10,000).
(A constructive purchase is also possible when you buy a coin while owning an appreciated short position on a substantially identical coin)
Cost Basis Adjustment
Next, Tom will have to adjust the cost basis of the AFP in the amount of the gain recognized. Therefore, the updated cost basis of the original BTC position will be $50,000 ($10,000 + $40,000).
Capital Gains Clock Resets
Further, the constructive sale resets the capital gains clock of the original long position. A new holding period starts on September 27, 2021 for the BTC purchased on January 15, 2020.
Being subject to the constructive sale rule is bad because it forces you to report gains and pay taxes without actually receiving any cash. Also, since it resets the holding period, you will have to wait longer to make the future gains subject to the favorable long-term capital gains tax rates.
Closed Transaction Exception
Luckily, you can get around the constructive sale rule if you plan transactions properly.
You can ignore the constructive sale if all of the following are true:
- You closed the short position during the taxable year or by the end of the 30th day after the end of your tax year.
- You held the appreciated financial position for at least 60 days from the day you close the short position.
- Your risk of loss was not reduced at any time during that 60-day period by holding certain other positions.
Continuing with the example above, say Tom closed the short position on January 15, 2022. He continued holding the original long position (1 BTC purchased on January 15, 2020) at least until March 15, 2022 (60 days from January 15, 2022). Further, he didn’t initiate any other offsetting positions to reduce his risk from January 15, 2022, to March 15, 2022. Here, Tom has fulfilled all three requirements. He can safely ignore reporting the constructive sale ($40,000) on his 2021 tax return.
Ambiguity & Administrative Burden on Taxpayers
The constructive sale rule applies only when you purchase a “substantially identical” offsetting position. What’s “substantially identical” is not clearly defined in the tax code and based on the facts and circumstances of each case. This may lead to confusion and inaccuracies. For example, it is reasonable to think that having a long position in BTC and shorting wrapped bitcoin (wBTC) would result in a constructive sale because they are substantially identical. 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 will be your responsibility to track constructive sales, adjust the cost basis and report gains if any. Cryptocurrency exchanges will not report constructive sales on their transaction history reports. It is also unlikely to see constructive sales transactions on the upcoming 1099-B forms. Finally, If enacted, this rule along with the wash sale rule will significantly increase the administrative burden for cryptocurrency taxpayers.
Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.