This scheme lets you mine bitcoin tax-free inside an IRA but may not pass muster with the IRS

For years, the IRS has taken a chunk of crypto mining revenue from all U.S. taxpayers. But one company is now trying to help crypto miners shield mining gains from taxes by letting them transact within an individual retirement account, or IRA. But tax experts question whether the arrangement will pass muster with the IRS.

Typically, when an individual mines for virtual coins, proceeds are classified as income by the U.S. government, and therefore, are subject to income tax.

But not everyone has enough money in the bank to cover that crypto tax bill. Some have to actually sell their mined coins for dollars in order to cover the tax, which then triggers capital gains taxes if the bitcoin has appreciated in value since they first mined it.

“American bitcoin miners are subject to double taxation,” said Ryan Radloff, CEO of IRA custodian Kingdom Trust, which offers the Choice IRA. Choice specifically caters to savers looking to add crypto assets to their retirement portfolios.

Radloff teamed up with hosting firm Compass Mining this week to offer customers an account that will allow them to mine bitcoin directly to their IRAs.

The process is relatively simple.

A customer first needs to buy mining hardware by using assets within their IRA. Radloff tells CNBC the equipment on offer ranges from $5,000 to $10,000 plus. Compass handles the logistics, from delivering those machines to data centers, to configuring and monitoring the gear.

While the Compass miners overwhelmingly generate bitcoin, they do also make some litecoin and zcash machines available. 

“After the miner is in the IRA, the newly generated bitcoins are treated like rental property income or stock dividends from assets that you own in your IRA – meaning they do not count against your contribution,” argued Radloff.

Radloff says that if clients subsequently choose to sell, the capital gains taxes will be deferred or eliminated completely if done within the IRA.

“You’re not getting access to the rental income, it just goes directly to the self directed IRA,” explained Shehan Chandrasekera, a CPA and head of tax strategy at CoinTracker.io, a digital currency tax software company that helps clients to both track their crypto across virtual wallet addresses and manage their corresponding tax obligations.

But not everybody is convinced the IRS will accept the arrangement.

“There are certain prohibited transactions within an IRA,” explains Lewis Taub, CPA and director of tax services at Berkowitz Pollack Brant, one of the largest public accounting firms in Florida. “One of these is providing of goods and services between the owner and the IRA plan. The IRS could most likely argue this set-up is a prohibited transaction,” said Taub.

The income generated from investing your IRA funds in mining cryptocurrency could be subject to the Unrelated Business Income Tax, if the mining is deemed a business or active trade.

Beyond that, Taub sees other negatives to the proposed system. Because bitcoin’s value has historically been subject to large swings, individuals will need to have a high tolerance for risk — or unshakable faith that the value of the coins mined will rise faster than inflation between the time they mine it and the time they’re allowed to take disbursements.

“Assuming for the moment that this is a legitimate transaction, the individual loses the use of the value of the asset…because distributions can’t be made from an IRA penalty-free until the owner reaches 59.5.”

Taub also notes that the IRS allows miners that are deemed to be running a business to take business deductions to reduce the taxable income from mining, but that these deductions are not available in an IRA. “There is no tax provision that would allow for these deductions within an IRA,” he said.

While Taub wouldn’t be comfortable advising any of his crypto clients to get involved with this, Chandrasekera says that criticisms such as these are conservative and assume the worst-case scenario.

“This is nothing new, to be honest with you,” argues Chandrasekera. “It is just another way of earning income inside a self-directed IRA account, because the advantage is that you’re not picking up income. You’re just kind of saving for retirement.”