Need for Guidance for California Purposes on the Application of Irc Section 1031 to Virtual Currencies and Other Digital Assets

JurisdictionUnited States,Federal,California
AuthorJames Creech
CitationVol. 32 No. 1
Publication year2023


James Creech

Annette Nellen

Roger Royse

This article is based on a paper presented by the authors for the California Lawyers Association Taxation Section's 2021 "Sacramento Delegation" on October 15, 2021. This paper highlights that the like kind exchange rule of IRC Section 1031 applies differently in California than for federal purposes. For most individuals, this rule will also apply to personal property held for business or investment purposes, most notably, virtual currencies. Thus, while there is no need for guidance in this area for federal purposes after the Tax Cuts and Jobs Act made Section 1031 only applicable to real property, there is a need for guidance from the Franchise Tax Board.1


In 2008 a nine-page whitepaper, "Bitcoin: A Peer-to-Peer Electronic Cash System" was released under the pseudonym "Satoshi Nakamoto" to explain bitcoin and how it worked. In May 2010, two pizzas were purchased using 10,000 bitcoin.2

Since that time virtual currency, often referred to as cryptocurrency,3 has become an active and growing element in numerous types of financial transactions.4 Today, CoinMarketCap5 lists over 6,000 types of virtual currencies, although most are not widely used or traded.

Like fiat currency, several virtual currencies can be used to acquire goods and services. Some are convertible to U.S. dollar or other fiat currencies but not all. Virtual currencies are generally decentralized and that trait has led to creation of similar items often called "tokens" or digital assets.

As new types of assets, virtual currency and other digital assets raise issues regarding the application of most federal and state laws including tax laws. The IRS first issued guidance on virtual currencies in March 2014 via subregulatory guidance—Notice 2014-21. A key point in this guidance is that convertible virtual currency6 is treated as property for tax purposes rather than a foreign currency. Where specific guidance is lacking, the general tax rules governing property should be applied.7

Treatment of virtual currency as property means that whenever it is used to acquire goods, services or a different virtual currency or digital asset, an exchange occurs. Exchanges of property held for business or investment purposes requires consideration of section 1031 on like-kind exchanges, which if applicable, is a mandatory provision.

The Tax Cuts and Jobs Act of 2017 (P.L. 115-97; 12/22/17) changed IRC section 1031 on like-kind exchanges to only apply to real property for exchanges completed after December 31, 2017. Thus, for virtual currency held for investment or business purposes, the like-kind exchange rule does not apply for exchanges after 2017, and it is unlikely the IRS will issue formal, binding guidance on such transactions.8

California did not fully conform to the TCJA change to section 1031. In California, the pre-TCJA version of section 1031 continues to apply to individuals filing as head of household, surviving spouse, or married filing jointly with adjusted gross income less than $500,000 and taxpayers filing as single with adjusted gross income less than $250,000 for the tax year in which the exchange begins. Thus, the question

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of how section 1031 applies to virtual currency and other digital assets continues to be an issue in need of guidance in California.

We encourage the Franchise Tax Board (FTB) to issue such guidance as it will be a tremendous benefit to owners of virtual currency and other digital assets as proper understanding and application of section 1031 is important given that it is a mandatory provision.

This paper provides background on virtual currency, some other digital assets, and section 1031 as applied to intangible assets and offers suggestions for the guidance we encourage the FTB to issue.


For tax purposes there are four main definitions of what constitutes virtual currency. The root definition of virtual currency that all other tax definitions flow from is a 2013 FinCen definition that states "In contrast to real currency, "virtual" currency is a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction."9 Other similar but slightly different definitions are found in Notice 2014-21 and Revenue Ruling 2019-24.

The current IRS definition is found in the IRS's virtual currency FAQs Q1: What is a Virtual Currency? The IRS defines the answer to what is a virtual currency as:

Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency ("real currency"), that functions as a unit of account, a store of value, and a medium of exchange. Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency. The IRS uses the term "virtual currency" in these FAQs to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency. Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes.

The legal definition of a virtual currency is far different from a technical explanation of how virtual currencies work. To function as a digital representation unit of account or store of value, virtual currencies are commonly recorded and transferred on a distributed ledger or blockchain. The use of a blockchain allows for a particular community of users to agree upon ownership of particular units of the blockchain associated with public keys and to transfer ownership from one agreed upon owner to the next. In many ways this blockchain can be thought of as a digital land registry where one agreed upon owner can transfer their interest in an address to a new owner if the collective body of users can trace the transferor's ownership back to the original creation of the address.

Just as each county has its own set of rules on how deeds are to be formalized and perfected, so does each blockchain. Some, like bitcoin, have limitations on the number of coins and block size that incentivize users to prioritize coins as a store of value. Others, such as Ethereum can run smart contracts that let users build on top of the verified ownership and secure transfer protocols. Still others, such as Solana, can support tens of thousands of transactions per minute and promote the Solana blockchain as an ideal method to make payments.

Each of these blockchains and systems that enable them to function have much in common. They are vast communication hubs where thousands of computers can work together to verify ownership and transfers. They have a precise order of transactions where space on the blockchain has established owners, and they have an incentive structure that allows the transfers to be completed in a decentralized environment. Finally, the ownership is fundamentally the same. Each virtual currency owner has possession over a unit of storage on this distributed ledger.

Despite the IRS's pronouncement that virtual currencies are property most of the units of storage are fungible. A newly created bitcoin in 2010 is substantively identical to a bitcoin created in 2021. This technological fungibility allows virtual currencies to be traded on exchanges at more or less the same price in U.S. dollars.

Recently a new type of token has been built on top of several blockchains.10 Like the fungible tokens, Non-Fungible Tokens or NFTs are part of the blockchain and share many of the same attributes such as the fungible token. However, as the name implies, there is only one NFT per address. Whoever owns that specific address also owns the NFT and any rights associated with the NFT. The NFT may represent various

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assets including artwork, trading cards, name or image of someone, and various rights including copyright.


Section 1031(a)(1) of the Internal Revenue Code of 1986, as amended (the "Code") provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if that real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment. Section 1031 is a mandatory provision, not an elective one. To avoid the deferral treatment, taxpayers must structure a property transaction to fall outside of section 1031, such as by selling the property rather than exchanging it.

Generally, if a transaction qualifies for section 1031 treatment, any realized gain (but not loss) will be recognized to the extent of the sum of the money (including liabilities assumed) received and the fair market value of nonqualifying property received.11 Qualifying property for 1031 purposes is property of a like kind held for productive use in a trade or business or for investment, but not property held primarily for sale.12 Section 1031 is intended to apply to transactions where the taxpayer's economic situation following the exchange is essentially the same as it had been before the transaction.13 Thus, both the relinquished property and the replacement property must be held for either productive use in a...

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