ZGL wallet: achieve zero gain/loss for tax purposes with coin control

[Dabs]

Well, as a "normal" user of bitcoin, I like to combine all the coins I own into one output every now and then, mostly to avoid paying future transaction fees for very large (in bytes) transactions. The history of those coins do get "lost".

The whole concept of a ZGL wallet is interesting to me, and I might actually use one, just so when the day comes I may need to file any kind of gains or losses, then all I need to do is click "print" and give that to the BIR (the Philippine equivalent of the IRS).

Like you, I'm not in the US, but we keep watch what they do.

So far, our government hasn't said anything about virtual currencies. They also haven't said anything about encryption for the longest time. I keep tabs on the my local government's stand on a few things such as those two and firearms, and since the topic is the United States, a lot of Americans are aware of their 2nd amendment issues.

Slightly off-topic:

I understand Canada is a little bit different (then there is also the government's stand on cannabis). The Philippines is almost a US state, except it isn't. (There are other politics involved, that's another story.) But then you always have Americans coming here, even US forces conducting military exercises, US Navy ships patrolling nearby pretending they don't own what China is claiming ... okay ...

[smooth]

Well, as a "normal" user of bitcoin, I like to combine all the coins I own into one output every now and then, mostly to avoid paying future transaction fees for very large (in bytes) transactions. The history of those coins do get "lost".

The history gets lost in the wallet, but according to the recent IRS guidance, that doesn't let you off the hook for keeping track of the history for tax purposes. You still appear to be required to keep track of the original history to report gains under a FIFO rule or possibly other rules such as using specific lots.

I suppose a wallet could be constructed that would recognize that certain coins are made up of a combined lot of several other lots of coins, and then produce tax-compliant reports accordingly.

I'm not sure whether you can treat the mere act of combining the coins as realizing the gain or loss. I would guess not, but my confidence on that is low.

[Dabs]

As usual, I am reminded of the very old question that gets asked a lot around here. "How many books do you keep?"

There are two important people you need to have: an accountant, for your taxes, and an attorney, for the legal stuff. I keep them separate, but it's not a bad idea to have one person be both (I've seen accountants who are taking up law, and lawyers taking up accounting, and some of my friends have the letters ATTY in front of their name as well as CPA on the end.)

[fryarminer]

I like this concept a lot - the only thing that would make me afraid of it is if it was an online service and not a stand alone program. I would want it to work without an internet connection. How do I know that a wallet designed to help regarding taxes is not reporting to the IRS in the background?
If at the end of the day I could print out my own report and then choose to use it or not use it, the rest of the concept is premium. I like the idea of merging coins purchased at different prices.

[Peter R]

Well, as a "normal" user of bitcoin, I like to combine all the coins I own into one output every now and then, mostly to avoid paying future transaction fees for very large (in bytes) transactions. The history of those coins do get "lost".

The history gets lost in the wallet, but according to the recent IRS guidance, that doesn't let you off the hook for keeping track of the history for tax purposes. You still appear to be required to keep track of the original history to report gains under a FIFO rule or possibly other rules such as using specific lots.

Yes, Smooth made this more clear than I did above.  If your "drops become and ocean," your cost basis for the ocean becomes the weighted-average of the cost basis of the individual drops.  

[Peter R]

I like this concept a lot - the only thing that would make me afraid of it is if it was an online service and not a stand alone program. I would want it to work without an internet connection. How do I know that a wallet designed to help regarding taxes is not reporting to the IRS in the background?

I'm glad to hear that you like the idea.  

In my mind, ZGL becomes simply an (open-source) add-on for existing wallets like Amory, Multibit, Electrum, etc.  So the question is whether you trust these wallets to not report your transactions.

In order to forge ZGL coins, the wallet needs to know the real-time bitcoin price.  This is why the wallet needs a live connection to a "bitcoin price server."  This doesn't mean, however, that the ZGL wallet must be a web-wallet hosted on a server.  The only use case where ZGL doesn't really work is for an off-line Armory wallet, but very few people are making day-to-day purchases using an off-line Armory wallet anyways.  

If at the end of the day I could print out my own report and then choose to use it or not use it, the rest of the concept is premium. I like the idea of merging coins purchased at different prices.

This is precisely the idea.  The wallet would provide two reports:

1.  A report of all the swaps where you realized a taxable gain (or loss).

2.  A report of all your ZGL purchases (where no gain or loss was realized).  

This is your private information and you can do with these reports as you wish.  I believe the current tax law says that you should voluntarily submit #1 to declare your capital gains or losses, but whether you should submit #2 is still up in the air.  

[smooth]

Well, as a "normal" user of bitcoin, I like to combine all the coins I own into one output every now and then, mostly to avoid paying future transaction fees for very large (in bytes) transactions. The history of those coins do get "lost".

The history gets lost in the wallet, but according to the recent IRS guidance, that doesn't let you off the hook for keeping track of the history for tax purposes. You still appear to be required to keep track of the original history to report gains under a FIFO rule or possibly other rules such as using specific lots.

Yes, Smooth made this more clear than I did above.  If your "drops become and ocean," your cost basis for the ocean becomes the weighted-average of the cost basis of the individual drops.  

This is not clear. The question I have is whether "melting down" coins and using those to create new coins is itself a taxable event, or whether you actually have to engage in trade to constitute a taxable event. I think the latter.

[Peter R]

Well, as a "normal" user of bitcoin, I like to combine all the coins I own into one output every now and then, mostly to avoid paying future transaction fees for very large (in bytes) transactions. The history of those coins do get "lost".

The history gets lost in the wallet, but according to the recent IRS guidance, that doesn't let you off the hook for keeping track of the history for tax purposes. You still appear to be required to keep track of the original history to report gains under a FIFO rule or possibly other rules such as using specific lots.

Yes, Smooth made this more clear than I did above.  If your "drops become and ocean," your cost basis for the ocean becomes the weighted-average of the cost basis of the individual drops.  

This is not clear. The question I have is whether "melting down" coins and using those to create new coins is itself a taxable event, or whether you actually have to engage in trade to constitute a taxable event. I think the latter.

Yes, that is the point that is unclear.  

I was just referring to the fact that the cost basis of the "melted down" coin becomes the weighted-average of cost-bases of the inputs (which is true whether or not the "melting process" is a taxable event).

EDIT: thinking about this more, if the "melting process" is a taxable event, then you would potentially have thousands of such events depending on how you split and merge your individual coins, even if you never sell or trade a single satoshi.

EDIT 2: Smooth, I think you may be on to something here.  If modifying your personal property is a taxable event, then many people would be required to report normal everyday events even if they don't sell or trade their property.
 

[smooth]

I was just referring to the fact that the cost basis of the "melted down" coin becomes the weighted-average of cost-bases of the inputs (which is true whether or not the "melting process" is a taxable event).

Maybe. In its guidance the IRS has stated a LIFO rule for virtual currencies. With LIFO even if you melt-and-combine when you do a trade it could be that your cost basis is not derived from either of the coins you melted. If you are able to use the specific lot method, which seems likely but is not clear from the guidance, then the weighted average calculation is correct, but probably have to identify the original purchase date and price if the melting process is not a taxable event (reset of basis).

Also, let's not forget about holding period. LIFO might be more advantageous if it shifts more of your gains into the long-term category. If you buy two coins today, melt them together, and then spend that new coin, the tax treatment might ignore both the purchase and melting and consider your basis and holding period from some coin you bought long ago.

All this remains to be worked out. Some of this (for example preference of long term over short term holdings) could also be implemented in a wallet.

[Peter R]

I was just referring to the fact that the cost basis of the "melted down" coin becomes the weighted-average of cost-bases of the inputs (which is true whether or not the "melting process" is a taxable event).

Maybe. In its guidance the IRS has stated a LIFO rule for virtual currencies.

Thanks for your continued help with ZGL, Smooth.  

May I ask where your read about the LIFO recommendation?  I didn't see LIFO mentioned at least in Notice 2014-21 (http://www.irs.gov/pub/irs-drop/n-14-21.pdf)

Q-5: How is the fair market value of virtual currency determined?

A-5: For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.

Q-6: Does a taxpayer have gain or loss upon an exchange of virtual currency for other property?

A-6: Yes. If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency. See Publication 544, Sales and Other Dispositions of Assets, for information about the tax treatment of sales and exchanges, such as whether a loss is deductible.


When I read this, it sounds to me like you should value your coins using market rates and a reasonable and consistent accounting system to calculate your adjusted basis.  I think ZGL is reasonable and it is definitely consistent.  

I still agree we need legal clarity here...

[smooth]

I was just referring to the fact that the cost basis of the "melted down" coin becomes the weighted-average of cost-bases of the inputs (which is true whether or not the "melting process" is a taxable event).

Maybe. In its guidance the IRS has stated a LIFO rule for virtual currencies.

Thanks for your continued help with ZGL, Smooth.  

May I ask where your read about the LIFO recommendation?  I didn't see LIFO mentioned at least in Notice 2014-21 (http://www.irs.gov/pub/irs-drop/n-14-21.pdf)

You are correct. I must have seen LIFO in one of the (apparently inaccurate) second hand reports, but it seems it didn't come from the IRS.

[fryarminer]

Peter R, I'm in. This is an excellent innovation.

[Dabs]

I think ZGL can still work on offline wallets like Armory. It would simply use what it knows at the time you create the transaction, or the offline part will ask the user to input the current bitcoin rate. Or the online part of the ZGL wallet grabs this for you and sends it to the offline part.

Which you can see, since the offline part will have to sign the transaction.

[datafish]

This may be a slightly off-topic question, but imagine if someone creates a unique product or service and sells it on a web site for bitcoin.  They only list the price in bitcoin, and there is no comparable product or service on the market.  If you purchase this item, how would you calculate your capital gains if there is no reference fiat price?  I don't think you can just use the current exchange rate as a basis.  What if this product were made available a year ago and the BTC price never adjusted to reflect the changing exchange rate?

[Dabs]

@datafish, what kind of product or service would that be? Is it truly unique? I think I've seen everything you can possibly call a product or service, and nothing is unique in the sense that all of them are merely variations of something else.

Therefore, there would always be some sort of fiat valuation of it.

Unless you have a completely new invention.

Or you are selling alt-coins.

So how much are the alt-coins worth? What if, instead of buying a product or a service, I trade my BTC to buy LTC? When you open that up, you can also trade BTC for any of the literally hundreds of other coins (no matter how worthless.)

Now, I understand LTC has a price in USD. But most of the other coins do not directly have a fiat price. They are mostly pegged to the bitcoin.

A popular alt is DOGE. It does not have a fiat exchange as far as I am aware. I think LTC has a lot of exchanges available. One of the larger ones is BTC-E, and that does have some other fiat / virtual currency pairs.

[datafish]

@datafish, what kind of product or service would that be? Is it truly unique? I think I've seen everything you can possibly call a product or service, and nothing is unique in the sense that all of them are merely variations of something else.

I don't have anything specific in mind; I was just thinking out loud. What if you used BTC to buy early shares in Mastercoin or Ethereum? There is no clear valuation in a virtual startup on the first day of issuance, is there? Would you pay capital gains sometime later, once the startup becomes successful and you use the proceeds to buy some conventional product or service?

[Peter R]

@datafish, what kind of product or service would that be? Is it truly unique? I think I've seen everything you can possibly call a product or service, and nothing is unique in the sense that all of them are merely variations of something else.

I don't have anything specific in mind; I was just thinking out loud. What if you used BTC to buy early shares in Mastercoin or Ethereum? There is no clear valuation in a virtual startup on the first day of issuance, is there? Would you pay capital gains sometime later, once the startup becomes successful and you use the proceeds to buy some conventional product or service?

For the time being, I think the "answer" you'll receive is that the amount of BTC someone trades converted to $ at the time of the trade is the valuation.  As bitcoin use grows, I think this answer will be seen as computationally ambiguous and will be rephrased to reflect reality.

There is already an area of ambiguity: what if you trade a bitcoin for a bitcoin?  Clearly, if you sell a bitcoin for $ and immediately buy it back, this is a taxable event and if you realized a gain you are required to report it (you can't do this to realize losses however, as time limits apply).  If you sell a bitcoin for litecoin and immediately buy it back, again you may have realized a gain.  If you use a coin swap service to swap your coin for a completely unrelated coin (0% taint), then again you've engaged in trade at arm's length and if you realized a gain then the IRS will gladly accept payment.

But what would the current tax law say about a coinjoin transaction?  If you use a coinjoin transaction to move your coins from A to B (you control both end points), is this a taxable event?  You are engaging in trade with an arm's length party in a sense, but since you retain control (coinjoin is trustless) you never really trade your bitcoins (yet your taint profile changes).  It's ambiguous--there is no physical analog to compare it to.    

To conclude, I think bitcoin is working exactly as it should.  It is showing the complexity and ambiguity of the current tax system and wakes people up to the fact that you cannot be 100% compliant.  If everyone used bitcoin, however, the tax code could be overhauled into a few pages of C++ code.  


I have ideas for how one could create a tax system that is unavoidable (no need to file anything) and completely voluntary at the same time.  But that is the topic for a different thread….

[datafish]

To conclude, I think bitcoin is working exactly as it should.  It is showing the complexity and ambiguity of the current tax system and wakes people up to the fact that you cannot be 100% compliant.  If everyone used bitcoin, however, the tax code could be overhauled into a few pages of C++ code. 

The way I see it, Bitcoin and other open-source, p2p projects are collectively an attempt to overhaul the current political and legal system into a large code base.  We're not there yet, however, and the vested interests will not go without a fight.

[Dabs]

@datafish, what kind of product or service would that be? Is it truly unique? I think I've seen everything you can possibly call a product or service, and nothing is unique in the sense that all of them are merely variations of something else.

I don't have anything specific in mind; I was just thinking out loud. What if you used BTC to buy early shares in Mastercoin or Ethereum? There is no clear valuation in a virtual startup on the first day of issuance, is there? Would you pay capital gains sometime later, once the startup becomes successful and you use the proceeds to buy some conventional product or service?

Yes, I mentioned alt-coins. Those things don't have fiat value yet, but like Peter says, most will consider the fiat value of the bitcoin value as the value of the alt-coin.

So, now there are a ton of alt-coins, and in an attempt to peg a value to them, some are accepting IPOs for pre-mined coins. The fiat value of those coins will therefore be equivalent to the bitcoin value converted to fiat at the time of the transactions.

The value of the coins later goes up or down on it's own, depending on the supply and demand once people start using those coins, trading them, exchanging them, etc. Most are still pegged to the bitcoin. Very few are pegged to any other value.

At least one is trying to disassociate it's own value separate from bitcoin, but using it's own value. Basically the bitcoin value will follow that coin's fiat value, not the other way around.

Only time will tell. All of these coins are much too young to really have any value (but still, people are sending BTC / fiat.)

[smooth]

What if you used BTC to buy early shares in Mastercoin or Ethereum? There is no clear valuation in a virtual startup on the first day of issuance, is there?

Sure there is. Why would you pay BTC for something that isn't worth at least what you paid for it. Why would the seller take BTC that is worth less than what he is selling?  Willing buyer + willing seller = fair market value.