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

[Peter R]

The recent IRS guidance changes no laws regarding the tax treatment of bitcoin; however, it gives clarity to individuals and businesses.  I believe this clarity is necessary in order to push forward adoption.

Reading user comments, I get the sense that some people are concerned about gain/loss accounting paperwork for day-to-day purchases should they choose to report to the IRS.  Barry Silbert mentioned that automated wallet software is ready and the owner of https://bitcointaxes.info has been promoting his website on the forum.  So we already have this and more will soon come.

But Holliday just said something that blew my mind:

…FIFO…LIFO...debate about how to pick which coin to spend for taxes purpose…LIFO…FIFO…

Of course you can pick if you are using a wallet with coin control.

Because of this property of bitcoin, it is possible to design a wallet that automatically organizes your day-to-day spending such that the capital gain is identically zero for each and every purchase that you make:  

If you have a sufficient amount of coins acquired both above and below the current bitcoin price, then it is always possible to create a new coin that is a linear combination of your existing coins that has a gain/loss for tax purposes of identically zero.

Assume the current price of bitcoin is $600, and assume that you control Coin Set A acquired at $200 (gain of $400) and Coin Set B acquired at $1200 (loss of $600).  If you wish to purchase a coffee for $2 and not deal with gain/loss accounting, your wallet can automatically select a suitable combination from the two sets of coins such that the present value is $2 (to pay for the coffee) and the gain/loss is identically zero (to simplify your taxes).  

In[1120]:= Solve[{400 a - 600 b == 0, 600. (a + b) == 2}, {a, b}]

Out[1120]= {{a -> 0.002, b -> 0.00133333}}

Provided your wallet has real-time BTC price data from a reliable source, and provided your wallet has knowledge of your cost basis, it would know to purchase your coffee using 2.0 mBTC from Coin Set A and 1.33333 mBTC from Coin Set B.  In other words it would forge a ZGL (zero gain/loss) coin specially for this purchase.  

ZGL coins are created in real time (they are "current") such that at the moment of creation (spending) your gain/loss is identically zero.  

The ZGL wallet does not allow you to avoid incurring capital gains.  Instead, it allows you to defer realizing capital gains over a long sequence of day-to-day transactions, effectively lumping the gain/loss in a much smaller number of events where a gain or loss was realized (coin swaps).  This reduces paperwork for both the filer and the IRS, and helps to preserve the privacy of your day-to-day transactions.  Its simplicity makes it easier to comply with US tax law, increasing expected revenue for the IRS.  

The way these "lump sum" capital gains work is as follows: eventually, if the bitcoin price continues to rise, your wallet will run out of "high cost basis" coins and will no longer be able of forge ZGL coins.  I think the most effective way to realize a capital gain for tax purposes is to use a coin swap service (also known as a mixer).  Your wallet would send 1 BTC + fee into the mixer and receive a new 1 BTC coin sharing 0 taint with the original coin.  Since this is a new piece of property exchanged at arm's length, you are required to recognize the capital gain on this "low cost basis" coin you just swapped.  Your ZGL wallet would automatically initiate these swaps when required, logging all pertinent tax data to ensure compliance with US tax laws.  When filing your taxes, you would report each of these swap events where you realized a capital gain or loss.  For example, you may report 12 such events if the price over the year was rapidly increasing, and perhaps 0 such events in a declining market.  

From my preliminary research, it seems the ZGL concept is on solid legal grounds.  However, there is one unresolved question: is there a requirement to report the ZGL transactions that did not result in a capital gain, or is it sufficient to report only the transactions where a gain was realized but keep private records such that you could prove your claims if audited?  I have posted a poll question to get us thinking about this.  

[1714016591]

1714016591

[1714016591]

1714016591

[1714016591]

1714016591

[seriouscoin]

I probably dont remember correctly,

but by Coin Set X, you mean tx X and not Wallet or Address X right?

[smooth]

The idea is that if you have some coins purchased below the current price and some coins purchased above the current price, then it is always possible to create a new coin that is a linear combination of your existing coins that has a gain/loss for tax purposes of identically zero.

Good idea.

Small correction to how you stated it though. You have to have not just "some" coins purchased below and above, but a sufficient number. which depends on the relationship between the current price and the prices at which they were purchased. Which is to say your little solver needs constraints on a and b.

A simple example would be if you have coins at purchased at 1 and coins purchased at 100 when the current price is 2. You need a lot more of the 1 coins to make this work. I don't think you can realize losses by just doing a quick round-trip trade either, due to the wash sale rules, though I think you can realize gains that way.

But in many (less contrived) instances this should work and should greatly reduce the number taxable events, especially on small transactions like buying a cup of coffee.

[Peter R]

Small correction to how you stated it though. You have to have not just "some" coins purchased below and above, but a sufficient number. which depends on the relationship between the current price and the prices at which they were purchased. Which is to say your little solver needs constraints on a and b.

Thanks for helping to improve the accuracy of that statement Smooth.  I have updated the OP to reflect (it is important to be precise with our logic).

As a note to readers, the ZGL-wallet (zero-gain/loss wallet) does not allow you to permanently avoid paying capital gains taxes.  Instead, it allows you to defer realizing capital gains over a long sequence of day-to-day transactions, effectively lumping the gain/loss in a much smaller number of events where a gain or loss was realized (bitcoin/dollar trades).  

ZGL-coins are created in real time (they are "current") such that at the moment of creation (spending) your gain/loss is identically zero.  In other words, ZGL-coins are currency.  

Note also that this wallet would be difficult to use when bitcoin is consistently making all-time highs (e.g., such as November 2013).

[RodeoX]

This is an interesting idea. I use the "first out" accounting method for calculating my tax. It may be possible to better my tax situation using something like this. I could spend certain coins to control my income from capitol gains in a given year. At least I think that's right.

[Peter R]

Let's assume a ZGL wallet exists and is functional.

Will these wash transactions need to be reported to the IRS? Obviously, it makes no sense to report them, but I've never known bureaucracy to make much sense. I'm assuming they will want to actually see the capital gains offset the capital losses, but I don't like assuming things.

My thinking is that spending ZGL coins would not be subject to any reporting requirements, although I'd like to hear DeathAndTaxes or BCB's opinion on this matter.  There is provably zero gain/loss on each transaction.  If you have a capital loss (or zero gain) on a normal transaction, at least here in Canada, you aren't required to report it.  

If you were audited, then you'd have a paper trail that proves the transactions were all zero gain/loss and that you were correct in reporting nothing.  

To readers: I am not a lawyer, accountant or tax specialist.  

[jbreher]

Thanks for expanding your thought. I didn't catch the implication when you stated that Holliday's post 'blew your mind' in that there other thread.

This is a really cool idea. I hope a SW team picks it up and runs with it.

[hello_good_sir]

More useful would be to something that attempts to maximize the capital gains that you report, up to a threshold.

In the US you pay 0% on long-term capital gains until your income gets to something like $72,000 for married people, and then the rate jumps to 20%.  Let's say that you make $50,000 per year.  I would want the software to ensure that I use coins such that I come out with exactly $22,000 in capital gains.  That way I pay no capital gains taxes this year and it also reduces my future tax liability.

[Peter R]

In this article, Georgetown Law professor Adam J. Levitin states that since bitcoin outputs are unique, each output could be subject to a different tax liability depending on its cost basis.  He argues that this decreases fungibility, but I argue that this gives validity to the concept of ZGL coins.  ZGL coins are dynamically fused by wallets with ZGL support to be "current" so that using them results in a capital gain/loss of identically zero.

http://www.theatlantic.com/technology/archive/2014/03/why-bitcoin-can-no-longer-work-as-a-virtual-currency-in-1-paragraph/359648/

[jbreher]

In this article, Georgetown Law professor Adam J. Levitin states that since bitcoin outputs are unique, each output could be subject to a different tax liability depending on its cost basis.  He argues that this decreases fungibility,

I think Levitin's argument is false. In my mind, the fungibility property of money is only relevant in exchange between parties. I think it only matters to the receiving party. To the receiving party, it is immaterial how long the giving party has owned it, nor how much capital gain the giver needs to pay.

While I have no specific education in the matter, it would seem to me that money's fungibility property is useful only in that it trivializes the receiver's assessment of the money's quality aspects. If a received bitcoin is indistinguishable from any other received bitcoin, the receiver need only think about overall quantity rather than quality of each bitcoin.

The giver needs to evaluate the quality of each bitcoin, but that determination is not coupled in time to the transaction. Indeed, this decision process is something that could plausibly be automated according a policy decision by the giving party - perhaps via some mechanism such as the ZGL wallet.

[acoindr]

I don't think this would work. This tax attorney advises using the FIFO method and nothing else for bitcoins.

The biggest issue for most bitcoin users is determining their basis. Because bitcoins are fungible, you run into the problem of tracing the cost of each bitcoin you hold. You cannot just arbitrarily choose your basis. The IRS will permit you to use the FIFO method (First in, First out). Any other method such as LIFO or Average Cost Basis is not advisable, particularly now that we know foreign currency rules do not apply

[smooth]

I don't think this would work. This tax attorney advises using the FIFO method and nothing else for bitcoins.

I don't follow his reasoning.

Because bitcoins are fungible, you run into the problem of tracing the cost of each bitcoin you hold.

Yet stock shares are fungible and the specific lot method is definitely allowed for stock shares.

[Peter R]

I don't think this would work. This tax attorney advises using the FIFO method and nothing else for bitcoins.

Levitin said that fact that each bitcoin was unique with a different cost basis would have complex (read: useful) tax accounting repercussions:

https://bitcointalk.org/index.php?topic=531135.msg5919137#msg5919137

I am hoping DeathAndTaxes and BCB provide comments, but my understanding now is that LIFO and FIFO are legal techniques used to simplify tax accounting.  You always have the option to pay taxes on the actual gain for each piece of property that you sell or trade.

What I am less certain of is this: what are your legal obligations if you exchange property in a single transaction without realizing a capital gain?

[acoindr]

I am hoping DeathAndTaxes and BCB provide comments, but my understanding now is that LIFO and FIFO are legal techniques used to simplify tax accounting.  You always have the option to pay taxes on the actual gain for each piece of property that you sell or trade.

VERY good point! True, there is always the option to be as anal with accounting as you like for tax purposes, and that's generally preferable.

What I am less certain of is this: what are your legal obligations if you exchange property in a single transaction without realizing a capital gain?

Good question, but I'd imagine as long as you could meticulously show there was no gain, then that's just what it is.

[BitEscrow]

 Changes nothing? Keep believing what you want to believe you retards. It means you can no longer run around; prancing like idiots saying you own everything.

[The_Gloomfrost]

I like the part which incentivizes buying coins when the price is relatively high. Your downside is essentially covered by future tax breaks. Nice!

[seriouscoin]

OP, how do you handles change  tx?

How do you convince the IRS that certain tx are just "changes" hence those tx outputs are still considered long term.

[seriouscoin]

OP, how do you handles change  tx?

How do you convince the IRS that certain tx are just "changes" hence those tx outputs are still considered long term.

I make a transaction from A to B with change going to C.

I control the private keys for A. I control the private keys for C.

How much more proof do you need?

what if C is also an address that you already have, "not new address"
Also how do you handle refund?

The address is being reused which makes it harder to audit.

Bottom line is, can this new wallet client manage at tx level and throw out addresses completely?

[DannyHamilton]

OP, how do you handles change  tx?

How do you convince the IRS that certain tx are just "changes" hence those tx outputs are still considered long term.

I make a transaction from A to B with change going to C.

I control the private keys for A. I control the private keys for C.

How much more proof do you need?

I have a 2 BTC output in my wallet that was purchased for $2 ($1 per BTC)

I have a 2 BTC output in my wallet that was purchased for $2000 ($1000 per BTC)

I need to make a 0.05 BTC payment to someone and the current exchange rate is $500.

How to I properly create the transaction for zero gain/loss, and what is the cost basis of each the new unspent outputs?

[seriouscoin]

Also would the IRS have to do analysis of the whole blockchain to properly identify the validity of certain tax payers?

Say in the change example, if C is a new address which IRS would not know until C is "spent"

In order to claim it as a long term gain, Holiday will say C is just change from previous tx between A and B.

IRS has to then analyze if what he said is true by checking C's previous tx....