After a five-year hiatus, the IRS issued Revenue Ruling 2019-24 and frequently asked questions (FAQ) on October 9, 2019. Prior to the ruling, the only formal guidance taxpayers had on the tax treatment of virtual currency transactions was IRS Notice 2014-21, which declared that virtual currency--also commonly referred to as cryptocurrency, or crypto for short--is to be treated as property for federal tax purposes. One item not specifically addressed in Notice 2014-21 was how taxpayers should report virtual currency they received from a hard fork or airdrop. Specifically, Revenue Ruling 2019-24 states that virtual currency received from a hard fork or airdrop is to be reported by the taxpayer as gross income, which will generally be treated as ordinary income, and thus subject to the taxpayer’s highest marginal tax rate.
A hard fork occurs when a cryptocurrency’s network protocol (i.e., the rules that describe how the network should operate) changes such that one group of network participants adopts the new protocol, while another group of network participants follows the old protocol, or one that is substantially different from the new protocol. In other words, the two protocols are incompatible with each other, and thus by extension, so are the networks. (A hard fork is also commonly referred to as a chain split because there are now two cryptocurrencies post the fork event.) Typically, crypto holders who held coins, or tokens, prior to the hard fork retain those same coins in the same crypto wallet and are issued new coins in a new wallet from the new crypto network equal to the number of coins they held at the moment of the chain split. In some respects, hard forks are analogous to a corporate spin-off; though not for tax reporting purposes, of course.
Airdrops are typically crypto tokens, or coins, that are distributed gratis to individuals who participate in a community. For example, the individual might be a crypto newsletter subscriber, or a user of a messaging application. Airdrops are primarily used for marketing and promotional purposes to raise awareness of a cryptocurrency. Contrary to what is written in Revenue Ruling 2019-24, airdrops and hard forks are mutually exclusive events. Semantics aside, the tax result is the same whether a taxpayer receives virtual currency via an airdrop or a hard fork: it’s all treated as gross income.
Perhaps the most prominent hard fork to date was Bitcoin Cash (BCH), which was spun off from Bitcoin (BTC) in August of 2017. Bitcoin holders received 1 BCH coin for 1 BTC coin. At the time of the fork, 1 BTC was worth approximately $2,8001 and 1 BCH was worth approximately $3402. Applying the guidance in Revenue Ruling 2019-24, a taxpayer who held 1 BTC at the time of the hard fork would recognize $340 of ordinary income, but only if the taxpayer was able to “exercise dominion and control” over the BCH. A taxpayer has dominion and control over the cryptocurrency if he has the ability to “transfer, sell, exchange, or otherwise dispose of the cryptocurrency.” If any one of these criteria is met, then the taxpayer has constructively received the cryptocurrency, and his tax basis would be established based on the fair market value of the crypto at that time. If the taxpayer cannot exercise dominion and control over the newly created cryptocurrency (which commonly happens when virtual currency is held at a cryptocurrency exchange), then the taxpayer does not recognize gross income until he constructively receives the cryptocurrency. Once the taxpayer is able to exercise dominion and control (typically when the cryptocurrency exchange credits the taxpayer’s account with the new cryptocurrency) then the taxpayer must recognize income on the date the crypto was constructively received based on the fair market value of the crypto at that time. Using the BCH example again, if the taxpayer custodied his 1 BTC coin at a crypto exchange that did not credit his account until December 20, 2017, then he would recognize approximately $4,355 of income, which was the price of BCH on that date3. That’s a nearly $4,000 difference from the date of the hard fork! As a point of reference, in October 2019, BCH was trading at around $220.
As a practitioner, how can you help clients who may have an “accession to wealth” resulting from a hard fork or airdrop of cryptocurrency?
- Ask your clients if they have ever transacted in virtual currency, because the IRS will most likely be asking taxpayers on Schedule 1 of Form 1040 for 20194, and because the agency has issued letters to taxpayers who may have transacted in virtual
currency in the past5. You’ll probably want to know about your clients’ crypto transactions before the IRS does.
- For those clients that have transacted in virtual currency, determine if they need to file an amended tax return for any prior years. Help them determine whether they’ve constructively received cryptocurrency as a result of a hard fork or airdrop.
Be aware that the Bitcoin network has had several hard forks, as have other cryptocurrencies.
- Ensure taxpayers are properly tracking the cost basis of their crypto holdings (per FAQ A36, specific identification is allowed as a cost basis tracking methodology). There are many online basis tracking software tools available to both taxpayers
and tax professionals that aid in tax lot optimization strategies.
- If your client is charitably inclined and wants to donate crypto, help him identify crypto assets that will offer the highest charitable deduction possible, being mindful that crypto held for one year or less receives a deduction that is equal to
“the lesser of the taxpayer’s basis in the virtual currency or the virtual currency’s fair market value at the time of the contribution.” Also, remember that charitable deductions are subject to AGI limitations, and a qualified
appraisal is required for donations greater than $5,000 in value.
- Utilize tax loss harvesting to offset capital gains. Because virtual currency is deemed property, and not a security, the wash sale rules do not apply should your client wish to purchase the same crypto asset within the 30-day window.
Explore with your clients who want to invest in cryptocurrencies the possibility of using a tax advantaged vehicle such as a self-directed IRA, thereby reducing the burden of basis tracking and tax uncertainty surrounding virtual currencies. Don’t forget about prohibited transactions in an IRA, though.
- Educate your clients about using cryptocurrency with unrealized losses to purchase personal-use property such as a home or car because then the cryptocurrency might not qualify for capital asset treatment, thus your clients might not be able to take a capital loss deduction. Best practice would be to sell the cryptocurrency and then use the proceeds from the sale to purchase the personal-use property.
Much like blockchain technology and cryptocurrencies, the taxation of virtual currency is multi-faceted and ever changing. CPA financial planners are well-positioned to help clients navigate this complex, exciting space.
If you would like to learn more about virtual currencies and related tax and financial planning considerations, please check out the following resources:
About the Author
Ryan Firth is the founder and president of Mercer Street Personal Financial Services, an independent Registered Investment Adviser (RIA) firm based in Houston, Texas. Mercer Street serves small business owners, young professionals, entrepreneurs, and growing families in the wealth-building phase of their lives. Find us @MercerStreetCo.