Alternative Investment

In-Kind Contributions – Virtual Currencies

Whether you are a new fund manager or you have been managing a fund for a number of years, one very common question asked by current and potential virtual currency fund managers is: Can my investors and I contribute appreciated virtual currency assets into my pooled investment partnership/hedge fund tax-deferred?

While virtual currencies are thought of by many as cash or currency, they are viewed by the Internal Revenue Service more similarly to securities (specifically property) and are, therefore, generally subject to capital gain/loss tax treatment. In 2014, the IRS issued Notice 2014-21, which addressed the tax treatment of Bitcoin and other virtual currency transactions. In the notice, the IRS concluded that Bitcoin and other virtual currencies are to be treated as property for tax purposes, and as such, general tax principles associated with the sale or exchange of property apply to all virtual currencies. It is also specifically noted that virtual currency is not defined as “foreign currency” for tax purposes.

Considering this, the tax effect of an in-kind contribution of virtual currency into a hedge fund would seem to most properly follow the same rules as an in-kind contribution of securities and other similar property. Typically, according to IRC §721(a), there is no gain recognized on the transfer of property in exchange for a partnership interest. However, there is one very specific exception to this code section that pertains to hedge funds and other similar vehicles which, based on its nature, could target a large number of unsuspecting virtual currency funds due to their often undiversified nature. If a property contribution is made to an “investment company” that results in the “diversification” of the contributor’s assets, then the contribution event is taxable related to unrealized gain positions, not loss positions, upon contribution. For more details related to the diversification rules, please read our latest thinking here.

Although, from a tax perspective, the mechanics of contributing virtual assets versus securities are similar, there are nuances that managers and investors need to be aware of. When virtual assets are contributed in-kind, it is essential the original cost, quantity, and purchase date are tracked by the person(s) contributing and that information is properly relayed to your administrator and tax advisers. This information is important because as these coins are sold, they must be identifiable and differentiated from the other assets in the portfolio. As coins are often bought and sold as fractional shares, tracking these coins, realizing the correct gain, and having the correct holding period can prove to be challenging if proper books and records are not kept. If the in-kind assets are unidentifiable amongst the portfolio, the transaction may be deemed to be taxable to the contributor on the date of contribution.

As is often the case with tax, there are exceptions to the exceptions, and careful tax planning should take place when considering any transaction, especially those that could cause unsuspecting taxable events. For the application of these rules, please consult your tax advisor or a Richey May specialist.

If you need further guidance about the tax effect of an in-kind contribution of virtual currency into a hedge fund, reach out to Steve Vlasak, Business Development Partner, Alternative Investments Practice.