Friend.Tech Shows How Complicated Taxing Crypto Transactions Can Be

The taxation of transactions on the popular new app differs dramatically depending on what kind of approach is taken.

In crypto, we often describe transactions in terms that borrow from analogous meatspace transactions. But the US tax code generally taxes transactions in accordance with their “substance” and not their “form,” meaning the terms people use to describe transactions are less relevant than what is actually happening.  

Unfortunately, it’s not always clear how to determine a crypto transaction’s substance, either because the transaction is really complicated or because its substance differs depending on whose perspective you take. Moreover, the IRS seems to break the substance-over-form rule fairly regularly (see this recent article I wrote).

That leaves taxpayers in a pickle. Do they determine the taxation of a transaction in accordance with its substance or its form? And, anyway, who (besides yours truly) has time to consider a transaction’s substance with US tax law in mind?

Friend.Tech, the crypto app du jour, illustrates how confusing the taxation of crypto transactions can be. This article considers how Friend.Tech transactions are taxed under a formalistic versus a substantive approach. The taxation of Friend.Tech transactions differs dramatically depending on which approach is used. 

The Background

On Friend.Tech, each user gets their own chatroom accessible only to their keyholders. Users can buy keys from the app using ETH. The price of each room’s key increases on a curve, getting more expensive with each purchase. Users can redeem a key at any time for its then-current ETH price. The app charges a 10% transaction fee on each purchase and sale, with 5% streamed to the devs and 5% streamed to the room moderator. 

Tax Treatment TL;DR

A formalistic approach results in capital gain or loss on entry and exit: a sale of ETH for your key, then a sale of your key for ETH.

By contrast, a substantive approach generally does not result in a tax event on entry except to the extent of your fee. On exit, you have ordinary income to the extent of any “new” ETH you take, and ordinary loss to the extent of any ETH you “lose.” Any such loss, and the fee you pay on entry, are deductible only if you can convince the IRS they are losses from a “wagering” (i.e., gambling) transaction, and then only to the extent you have wagering income in the same year. 

A Deeper Dive Into the Formalistic Approach 

1. Purchase of a key. ETH is property (See IRS Notice 2014-21). A formalistic approach treats keys as property, too. So, when you buy a key with ETH, you’re treated as selling the ETH for dollars and buying the key with dollars. You’d recognize capital gain or loss equal to the difference between the ETH’s dollar value and its basis (which is its dollar-value cost when you acquired it). Your basis in the key would be the dollar amount of the ETH sold, including your entry fee. 

2. Redemption of a key. Similarly, when you redeem the key for ETH, you’d recognize capital gain or loss equal to the difference between the dollar value of the ETH you receive and your basis in the key. 

3. Streamed fees and points. Streamed fees and points would be taxed to you as ordinary income at their dollar value when withdrawable. 

Capital gains on assets held for more than one year are taxed at preferential rates that top out at 20% (instead of at 37% for short-term capital gains and ordinary income). Capital losses are deductible only to the extent of capital gains for the year plus $3,000 of ordinary income; any remainder can be carried forward to future years. 

A Deeper Dive Into the Substantive Approach 

The problem with the formalistic approach is that when you initially exchange ETH for a key, you’re not actually selling the ETH. A sale requires a counterparty. Instead, you’re contributing the ETH into a pool. The key isn’t really a capital asset; it’s just a ledger entry representing your contribution to the pool. (That’s not to say a smart contract can never be a person. I’ve explained elsewhere that lots of smart contracts probably are tax persons, with potentially problematic results. But to be a person, a smart contract would need to be engaged in a business. Shifting ETH around isn’t a business).

By analogy, assume you and I each contributed $50 to a bank account, and you then withdrew $75. You wouldn’t have a capital gain on your withdrawal; you’d have ordinary income because 25 of my dollars shifted over to you. That is, in substance, what happens within Friend.Tech:

1. Purchase of a key. Your “purchase” of a key with ETH wouldn’t be treated as a sale of that ETH except to the extent of the 10% fee. The fee’s dollar value would be an ordinary expense, but its deductibility is questionable (see below). Your key would have the same basis and holding period as the ETH you contribute into the pool after the fee is paid.

2. Redemption of a key. If, after accounting for the exit fee, you get back more ETH on a redemption than you put in, you’d recognize ordinary income on the dollar value of that ETH. If you get back less ETH than you put in, you’d recognize ordinary loss on the dollar value of the missing ETH. The deductibility of the ordinary loss is questionable (once again, see below). 

   The ETH you get back would have the same basis as the ETH you put in, except that any “lost” ETH would reduce that basis proportionately while any “new” ETH would have a fair market value basis.

3. Streamed fees and points. Just as under the formalistic approach, fees and points would be taxed to you as ordinary income at their dollar value when withdrawable. 

As mentioned above, the deductibility of your entry fee and ETH losses under the substantive approach is questionable. That’s because Congress has historically been very reluctant to let people take non-business losses. In fact, unless a non-business loss fits into a very narrow set of categories, it is treated as a “miscellaneous itemized deduction.” Miscellaneous itemized deductions are completely disallowed for individuals under current law. And it would be really hard to establish that your losses are deductible as business losses unless posting on Friend.Tech is basically your day job.

The only exception from miscellaneous itemized deductions that might apply to Friend.Tech transactions is losses from wagering transactions. Those are deductible to the extent of your wagering income for the year, but net wagering losses “die” at the end of the year—they can’t be carried forward like capital losses. 

The tax code does not define “wagering transaction” for this purpose, but in another context defines “wager” to include a bet on the outcome of a contest, and defines “contest” to include a contest involving “popularity.” Perhaps that could accommodate Friend.Tech transactions.

Conclusion

Like many exciting crypto use cases, Friend.Tech raises some great tax questions. But the average U.S. taxpayer isn’t interested in great tax questions; they just want to know how much they owe the government. Our current tax system is not designed to accommodate the regular use of property as currency. So, sadly, until lawmakers rethink the tax rules with crypto in mind, tax policy will remain crypto’s frenemy.