The fortunes currently being made in Bitcoin and other cryptocurrency investments and trading offer unique opportunities for tax planning that other appreciated assets often do not. This article discusses one of those aspects: the importance of residency planning in reducing cryptocurrency tax liability at the state level.
What Makes Cryptocurrency Conducive To Residency Tax Planning?
Bitcoin and other cryptocurrencies are unique assets in many ways. But for residency tax planning purposes, these three factors make all the difference.
First, much of the taxable gain in appreciated cryptocurrency investment remains unrealized – that is to say, the investors have yet to sell or exchange their initial investment. This is due to the volatile nature of cryptocurrency values, but it’s also a result of the second factor.
Second, unlike traditional investments, the Bitcoin phenomenon has been driven by young disruptive investors, not the usual Wall Street sages with briefcases stuffed with earnings-to-value reports. Many of my clients made relatively small investments, either directly or through mining, in their early twenties, and now, as they enter their thirties, they find themselves sitting on millions or even tens of millions of untaxed appreciated cryptocurrency. Because younger people tend to be mobile, they can move anywhere before cashing out. Which brings us to the third factor.
Finally, for tax purposes cryptocurrency is treated as an intangible asset. This is critical, because as an intangible asset (explained below), cryptocurrency is taxed at the state level based on the residency of the owner when a sale or exchange takes place, not where it was purchased or mined. As a state on the cutting-edge of technology, California is the home of most of the new cryptocurrency wealth, waiting to be tax. It will make a big difference to the investors or traders if they cash out as California residents or, if they choose, after moving to a lower tax state.
What Cryptocurrency Is Not
This is usually the point where the author explains what cryptocurrency is and delves into an obtuse explanation of blockchains and hashing. Fortunately, for tax purposes, all that is irrelevant (and most successful cryptocurrency investors already understand how it functions). What matters is, what cryptocurrency is not. And it’s not currency. It’s true that the paper by Satoshi Nakamoto which founded the Bitcoin phenomenon, calls it “A Peer-to-Peer Electronic Cash System,” but the IRS doesn’t care, and it, not Nakamoto, sends the tax bills. The IRS taxes cryptocurrency as property. More specifically it is an intangible asset, much like a security. Now, cryptocurrency is in fact not a security but a new type of asset that enables decentralized (that is, peer-to-peer) apps, with the ultimate value of the asset tied to the value of the apps, which at this point is hard to monetize. But again, we don’t need to get into bitcoin investment advice here, just tax planning for those who luckily find themselves holding highly appreciated cryptocurrency, which is taxable as an intangible asset.
Taxing Intangible Assets
The downside of cryptocurrency being defined as an intangible asset and not currency is that it is taxable upon sale or exchange to the extent that the value has appreciated above basis (the value of the cryptocurrency when acquired). If an investor or trader converts bitcoins into US dollars on an exchange, a potential taxable event has occurred: he has sold the bitcoins. The appreciation, measured as the difference between what the bitcoins were worth when acquired versus their worth when sold, is taxable. If he buys more bitcoins with his bitcoins, he has exchanged the bitcoins, and again, the appreciation is taxable. Indeed, if he buys a shirt with his bitcoins, he has made an exchange, and it too is taxable as to any appreciation. And now you know, in case you didn’t already, why cryptocurrency isn’t currency, though it isn’t easy for the IRS to monitor such exchanges unless they audited.
But there is also an upside to the intangible status of cryptocurrency. It has no situs in the state where it is purchased or sold or exchanged. Rather, it is traced to the state where the owner resides, just like stock, when the taxable event occurs. Why is that important? Because the investor is only liable for state taxes in the state where he lives when he cashes out. And that is something he can control, if he plans far enough ahead. If he cashes out while residing in California, he faces a top rate of 13.3%. On a transaction with $1 million of taxable gain, that’s $133,000 in state income taxes. However, if he changes his legal residency to Florida or Washington or Nevada or some other zero income tax state before the taxable event, the state tax is zero.
Planning vs Planning Too Late
Here is where the demographics of cryptocurrency investment come into play. Generally, it is easier for younger persons to change legal residency from California to a lower tax state. They usually have fewer deep ties to the state, whether in the form of real property or family or employment. Most of my clientele who have successfully invested in bitcoin are unmarried and own few assets in California (or if they do they are easily liquidated). They can live and work anywhere. And if they move to a lower tax state before cashing out their cryptocurrency, but still want to enjoy California, they can purchase a vacation home afterwards.
But moving just before a large cryptocurrency sale or exchange is a bad idea. The rule California follows is, if you move to another state for the purpose of tax avoidance in a particular transaction, you are deemed not to have the requisite intent to change residency. This is obviously true for those who move from California to cash out their cryptocurrency, and move back to California shortly thereafter. The rule applies to any taxable transaction, whether a stock sale or an asset sale or a Bitcoin cash out.
That said, California cannot prevent residents from changing their legal residency to another state. If they follow the rules, they will become nonresidents. And if thereafter they sell or exchange their bitcoins, there is nothing the Franchise Tax Board, California’s taxing authority, can do about it. But legal residency is not intuitive, so planning ahead is the best way to proceed. In the best-case scenario, this means moving at the very least in the prior tax year before the cryptocurrency transaction. Sometimes that isn’t possible. And again, the FTB can’t stop people from leaving California. But the closer the move is to the cryptocurrency cash-out, the more likely there will be an audit with an unfavorable conclusion.
Moreover, for traders in cryptocurrency, as opposed to investors, it is even more critical to plan. Investors acquire cryptocurrency as a capital asset and hold it for future sale. In contrast, traders buy and sell cryptocurrency, often using sophisticated algorithms, in larger volume and with greater frequency. Qualifying as a trader requires meeting certain IRS criteria, since it results in various tax benefits, such as being able to use ordinary deductions unavailable to investors and being exempt from capital loss limitations. But since traders are buying and selling cryptocurrency constantly, they are engaging in taxable events. If they reside in California while engaging in trading activities, the income is subject to California tax. Many owners of bitcoins move from being passive investors to traders as they acquire more of the assets and have a more sophisticated knowledge of how to play the margins. If it appears the trading is leading toward significant taxable income, it might be time to do some residency planning. Obviously, Bitcoin trading can be done from anywhere.
In addition, many cryptocurrency investors also work in the financial industry, and many find themselves stationed in an overseas branch of their employer or are recruited by international firms. If that’s the case, and they left California for an offshore job, they need to be aware that special rules apply to residents who are employed in other countries. Those rules are generally unfavorable when it comes to changing residency. Therefore, if a Bitcoin investor is working overseas, he should do some planning before cashing out. California residency gets complex for offshore workers who move directly from California.
Finally, to make matters even more complex, the safe harbor rule of Revenue and Tax Code §17014, which provides a bright-line rule for California residents who work overseas for more than 18 months and meet certain other criteria, is unavailable for cryptocurrency investors who cash out for more than $200,000, and (maybe) for traders who have more than $200,000 in income from sales or exchanges of cryptocurrency. But I will discuss that in another article.
Sanger & Manes LLP is the premier law firm in California residency tax planning, consultations, audits and appeals. We have over two decades of success assisting Californians who want to change their legal residency, businesses moving their situs to other states, and nonresidents purchasing vacation homes or investment property in California. We serve a clientele of successful innovators and investors, including Bitcoin investors, retirees, professional athletes, actors, artists and global citizens able to live and work anywhere. Learn more at our website: www.calresidencytaxattorney.com.