June 22, 2021
In ILM 202124008 (the “Legal Memorandum”), the Internal Revenue Service (the “Service”) recently addressed whether an exchange of one cryptocurrency for a different cryptocurrency could qualify as a like-kind exchange under section 1031 of the Internal Revenue Code of 1986, as amended, if completed prior to January 1, 2018. The Service took a very narrow view of what it means to be “like-kind” in the context of three cryptocurrencies (Bitcoin, Ether and Litecoin) to conclude that an exchange involving such cryptocurrencies cannot qualify as a like-kind exchange. While the ruling will have limited direct applicability because the Tax Cuts and Jobs Act limited like-kind exchanges to real estate for exchanges occurring after December 31, 2017, the Service’s view that different types of cryptocurrencies are sui generis property may have broader implications.
Notice 2014-21 described virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value” that does not have status as legal tender in any jurisdiction. That is, the only value of cryptocurrency exists in its ability to be exchanged for other property. The Service has referred to virtual currency that acts as an alternative for fiat currency, such as Bitcoin, as “convertible” virtual currency. For U.S. federal income tax purposes, virtual currency is considered property. Accordingly, general tax principles applicable to property transactions apply to transactions involving convertible virtual currency.
Bitcoin, Ether and Litecoin are all forms of cryptocurrency, a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Distributed ledger technology is a protocol that uses independent digital systems to record, share and synchronize transactions, the details of which are recorded in multiple places at the same time (with no central data store or administrator). Cryptocurrencies may be used as a method of payment and certain taxpayers may transact in cryptocurrency for investment purposes.
Cryptocurrency exchanges can be thought of as digital platforms that allow users to trade one cryptocurrency for another cryptocurrency, as well as for fiat currencies (i.e., the U.S. dollar). As described in the Legal Memorandum, the possible combinations supported by an exchange are known as trading pairs. Major cryptocurrencies like Bitcoin and Ether typically may be traded for any other cryptocurrency and vice versa. However, it can be common on a cryptocurrency exchange that certain cryptocurrencies can be traded for only a limited number of other cryptocurrencies and cannot be traded for fiat currency at all. According to the Legal Memorandum, as an example, one popular cryptocurrency exchange supported more than 30 different cryptocurrencies, but almost all of them could be acquired with or traded for only Bitcoin, Ether or fiat currency.
Section 1031(a)(1) provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment solely for property of like-kind to be held either for productive use in a trade or business or for investment. Although like-kind exchanges can involve different types of real property, as an example, the Legal Memorandum posited that the nonrecognition of gain or loss under section 1031 is intended to apply to transactions where the taxpayer’s economic situation following the exchange is essentially the same as it had been before the transaction. As mentioned above, the Tax Cuts and Jobs Act, P.L. 115-97, amended section 1031 to limit like-kind exchange treatment after December 31, 2017, to exchanges of real property. Prior to 2018, section 1031 also applied to certain exchanges of personal property (including intangible property).
Treas. Reg. § 1.1031(a)-1(b) defines “like-kind” to mean the nature or character of the property and not the grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. The Service has long been restrictive about the types of property that can be treated as like-kind.
The Legal Memorandum relied on the fact that in 2016 and 2017, Bitcoin and Ether held a special position within the cryptocurrency market because the vast majority of cryptocurrency-to-fiat trading pairs offered by cryptocurrency exchanges had either Bitcoin or Ether as part of the pair. In other words, an investor wanting to acquire a cryptocurrency other than Bitcoin or Ether, such as Litecoin, would generally need to acquire either Bitcoin or Ether first.
Because of this difference, the Service reasoned that “Bitcoin and Ether played a fundamentally different role from other cryptocurrencies within the broader cryptocurrency market during 2016 and 2017. Unlike other cryptocurrencies, Bitcoin and Ether acted as an on and off-ramp for investments and transactions in other cryptocurrencies. Because of this difference, Bitcoin and Ether each differed in both nature and character from Litecoin.” As a result, the Service concluded that Bitcoin and Litecoin do not qualify as like-kind property for purposes of section 1031, and neither do Ether and Litecoin.
The Legal Memorandum looked closer into the role of Bitcoin and Ether in the cryptocurrency market to conclude that Bitcoin and Ether are “fundamentally different” from each other and thus do not qualify as like-kind property under section 1031. Despite both cryptocurrencies sharing similar qualities and uses, the Service concluded that they are fundamentally different from each other because of the difference in overall design, intended use and actual use: “The Bitcoin network is designed to act as a payment network for which Bitcoin acts as the unit of payment. The Ethereum blockchain, on the other hand, was intended to act as a payment network and as a platform for operating smart contracts and other applications, with Ether working as the ‘fuel’ for these features. Thus, although Ether and Bitcoin may both be used to make payments, Ether’s additional functionality differentiates Ether from Bitcoin in both nature and character.”
The Service appears to have taken an unnecessarily narrow view of the like-kind standard in its analysis to conclude that tax-free treatment under section 1031 was unavailable for exchanges involving Bitcoin and Ether, Bitcoin and Litecoin and Ether and Litecoin prior to 2018. The Service’s approach is interesting because it causes one to wonder how similar two cryptocurrencies would have to be for the Service to conclude they are like-kind. In fact, the Service’s reasoning is reminiscent of Rev. Rul. 82-166, where it concluded that gold bullion and silver bullion were not property of like-kind. While the two metals clearly have some similar qualities and uses, the Service ruled they are “intrinsically different metals and primarily are used in different ways” and that an “investment in one of the metals is fundamentally different from an investment in the other metal.” The Service’s historically narrow approach on when personal property is of like-kind is in stark contrast to the permissive approach with respect to real estate. The Treasury regulations under section 1031 explicitly state that city real estate is of like-kind with a ranch or farm and improved real estate is of like-kind with unimproved real estate.
In any event, while we welcome any guidance from the Service addressing the tax treatment of cryptocurrencies, the Legal Memorandum does little to answer the many important unanswered questions concerning this important asset class.
 2014-16 I.R.B. 938.
 Notice 2014-21; Rev. Rul. 2019-24, 2019-44 I.R.B. 1004.
 Rev. Rul. 2019-24 at 2.
 Similarly, an investor seeking to liquidate her holdings in a cryptocurrency other than Bitcoin or Ether, such as Litecoin, generally would need to exchange those holdings for Bitcoin or Ether first. Litecoin’s trading pair availability was substantially limited in 2016 and 2017.
 See Treas. Reg. § 1.1031(a)-1(c).