Be Aware of Tax Impact When Moving Investments Into Bitcoin ETFs

One of the biggest narratives in finance has been the launch of 11 Bitcoin exchange-traded funds in January. The Securities and Exchange Commission’s approval of ETFs is a huge step for the digital asset industry, as many will now be able to invest in Bitcoin through trusted financial institutions without many of the risks associated with holding it.

New investors seeking exposure to digital assets will find investing in one of the new ETFs fairly straightforward. However, those with existing Bitcoin investments who are looking to move into ETFs should know the potential tax implications of rotating funds.

Bitcoin Proxies Shuffle

Grayscale Bitcoin Trust has seen significant cash outflows since the approval of Bitcoin ETFs, mainly because investors have been moving out of GBTC and into ETFs due to the lower fees. The tax impact of such a move can differ greatly, depending on the investor’s position.

Investors who held GBTC in retirement accounts have nothing to worry about—selling GBTC to move into an ETF has no tax implications. This is also true for investors moving from any other Bitcoin stock or security, such as MicroStrategy Inc. or one of the Bitcoin mining companies such as CleanSpark or Bitfarms Ltd. While all these securities are proxies to Bitcoin, they’re held within traditional brokers, meaning that moving from any of these into a new ETF will be tax-free if done in a retirement account.

The outcomes for investors with GBTC in taxable accounts will depend on whether their position was an unrealized gain or loss. If the investor had an unrealized gain, selling this investment to invest in an ETF would trigger a taxable gain. This means the capital available for investors to reinvest in the ETFs is effectively diluted by the tax.

If the investor had an unrealized loss, however, the wash sale rule could apply. While the sale of GBTC to buy a different asset would technically be a different security, the tax code specifies that the wash sale rule applies when an investor “has entered into a contract or option so to acquire, substantially identical stock or securities.”

In this case, the key question is whether GBTC and the ETFs are substantially identical. If they are, no loss would be allowed on the sale, and the GBTC would get deferred until the replacement assets (the ETFs) are disposed of. In this case, if investors wish to claim losses from GBTC, they would need to wait 30 days from the sale of their GBTC to purchase an ETF.

What about selling MicroStrategy or Bitcoin mining companies to invest in the ETFs? If the investor has a gain, the outcome is the same—the investor must pay tax on any realized gains unless other capital losses can offset such gain.

If the investor has a loss, there is no need to worry about the wash sale rule as shares in MicroStrategy or a Bitcoin mining company wouldn’t constitute substantially identical stock or securities as the ETFs.

This is because despite of the amount of Bitcoin it holds, MicroStrategy is a different investment than an ETF—an operating company that also buys Bitcoin as a reserve asset. Mining companies are even more different as they carry additional risk. They’re not priced based on the price of Bitcoin alone but rather on many different factors, including their hash power, efficiency, governance, revenue, and profitability.

As IRS Publication 550 states, “Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation.”

Transitioning From BTC

Another flow of funds into Bitcoin ETFs may have surprisingly come from investors selling Bitcoin to invest in the ETFs. These investors may be trying to mitigate the risk of holding and storing their private keys and relying on an institutional custodian instead.

The sale of Bitcoin, regardless of motive such as investing in ETFs, is a taxable sale in which the taxpayer must report the gain or loss. Like GBTC and other investments, selling any appreciated asset will result in taxable gains.

But what if investors sell Bitcoin at a loss to invest in ETFs—does the wash sale rule apply then? The tax code doesn’t consider the sale of a digital asset as subject to the wash sale rule.

There have been discussions in Congress about adding digital assets to the language of Section 1091 of the tax code to address this loophole, but nothing has passed yet. This means that any investors selling Bitcoin at a loss to invest in the trusts should be able to claim such losses.

Simplifying Tax Reporting

Bitcoin ETFs offer a notable advantage in tax reporting over investing in Bitcoin directly. They allow investors to sit back and wait for the Forms 1099-B provided by their brokers for any taxable transactions involving ETFs, significantly simplifying the tax filing process. This simplicity is increasingly attractive to investors, particularly those less familiar with the intricacies of cryptocurrency taxation.

With rumors about the approval of an Ethereum ETF on the horizon, many of these issues will come up again, as investors diversify from other assets into new investment products. Investors must always be aware of tax implications prior to reallocating previously invested capital and plan accordingly.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

David Canedo, CPA, specializes in taxation of crypto assets and serves as a market development specialist at CryptoTaxAudit.

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