Trapdoor Arithmetic

Two Kinds of Reality

We are in the cryptosphere, a place of novel concepts, fun opportunities, and profit potential. It is easy to forget about another kind of reality: open spaces, black holes, rogue meteorites, pirates, oceans, and other inconveniences.

For now, that other reality is managed for everyone’s benefit by a good old tech of fiat currencies and taxes. By comparison, at the time of this writing, the total value of the cryptosphere is hardly above a hundred billion US dollars while the old tech is still commanding trillions in existing money supply and quadrillions in derivative instruments.

We will not argue with necessity and inevitability of paying taxes, sooner or later, to whichever country we live in. But how much is enough? Let's consider US laws.

Relevant Rules

A few basic tax concepts to be aware of. Under the current regime in US, we pay Federal and State taxes based on realized gains. “Realized” usually requires that we sell an asset for a “fiat" "old economy” currency, use an asset to pay for goods or services, or exchange it for another asset (ignoring derivatives). US tax rules currently treat cryptocurrency as a property, not as a “currency.” Thus, when one cryptocurrency is exchanged for another - one property is exchanged for another triggering a taxable gain.

There is an exception for non-recognition of gain if “like-kind” properties are exchanged. For now, the official position of tax authorities is that no two cryptocurrencies are of a like-kind. This could be questioned in some cases. For example, for Ethereum Classic and new Ethereum right after the fork, they seem to be perfectly the same. So, there may be some room. But let’s assume for our purposes here that we will not have a clear opportunity to exchange into another cryptocurrency without a taxable event.

Gains and losses realized from all the crypto and non-crypto assets are combined to the extent they are realized within the same tax year. If there are unused losses from prior years, they can also be thrown into the mix. For almost all the individuals in US, the tax year consists of full twelve months and ends on December 31st. Consequently, on January 1st, with the beginning of the fireworks festivities the “trap door” closes for the previous year.

The tax rates on net gains from crypto assets depend on holding period. Generally, if we hold an asset for one year and one day, we will pay about 12% less in Federal taxes than if we held it for a shorter period of time. The actual rate depends on a great variety of factors, plus the states. Combining both, we will assume 30% if holding for long term and 42% if for short.

A Case Study

Let’s consider a made up case of Joybabu the Second. He had bought a thousand bitcoins in 2010 for very little money. In 2017, he finally decided to diversify. He used one half of his stash to buy ten other crypto assets. Not to get the markets too excited, he had eased into these over six months, just in time for the New Year countdown.

He had done nothing else and saw his tax guru in March of 2018. At the same time, a fake news on rapid advances in quantum computing came out, the full moon did not shine quite as bright as before, and interest rates continued their steady climb, - all this caused crypto markets to take a dive by 40%. His tax man insisted that US government would only accept dollars. So, Joy is having to convert some of his holdings into the fiat.

If he sells bitcoins, he will realize more gain to be taxed the following year. If he sells the altcoins, then he will need to settle for a very bad deal, selling them cheaply, at a loss (remember, he just invested in them, thinking that they were already inexpensive and had a potential to go up). Out of 1,000 of bitcoins, he had exchanged 500 realizing gain, say $1Mil, and now must pay $300,000 (30%) in taxes. The current value is only $600,000. He is now forced to sell one half of his holdings while keeping only $300,000 in value.

The result would be much better if he had only bought $700,000 of altcoins and converted $300,000 to dollars right away. The drop in value would only be $280,000 leaving him with $420,000, $120,000 more than under the first scenario.

This example suggests that with all things equal, assuming that we don’t have a hot tip from a friend or a revealing dream, whenever we profitably exit large chunks of holdings, it is highly recommended to convert at least some portion of it into the dollars right away, at the same prices as we exchange them for other assets. Less than a year is too short of a period to count on any miracles, as cryptocoin markets are likely to stay very volatile with limited liquidity for some time.

The Trapdoor

What to do with the end of the year then? Ah, that’s a good question. Say, the 40% drop took place in December of 2017. Then Joy could have at least mitigated the negative outcome by selling or exchanging some or all of his altcoins to realize losses to balance the situation. We will not do the math here but he could have lost less. Hence the trapdoor. As soon as it is shut, the year ends, no more immediate remedies, the total amount of tax is fixed, and we are forced to convert into fiat not on the terms of our choosing. That’s the tax code’s ironic take on the trapdoor concept in modular arithmetics, working to reduce remainders to their minimum.

Disclaimers

I have not considered here a case of C corporations that pay tax at different rates and have different capital loss rules. Other points and possibilities were left out for now. Will post about them in due course.

Here I have to tell you to contact your own tax adviser for a recommendation specific to your situation. Although if you have read thus far, you probably know this already.