A New Source of Pain for Crypto-Investors: The (Unfortunate) Taxation of Hardforks and Airdrops

The IRS has released rules detailing the taxation of hardforks and airdrops of cryptocurrencies, and they aren’t pretty. On the bright side, if a hardfork occurs and is not followed by an airdrop (meaning you do not receive units of a new cryptocurrency as a result of the hardfork), you do not have taxable income. On the not-so-bright side, if you do receive units of a new cryptocurrency as a result of a hardfork followed by an airdrop, you likely have taxable income, ordinary in character (meaning no help from favorable capital gains tax rates), equal to the fair market value of the units received at the time you received them.

Let’s back up…

What is a hardfork? At a high level, a hardfork is when a cryptocurrency is changed in such a way that it is effectively a new cryptocurrency, but the original cryptocurrency also continues to exist. The original currency (e.g. Bitcoin) splits (or “forks”) into two currencies (e.g. Bitcoin and Bitcoin Cash) at a certain moment, and from then on, the two currencies both exist. Whether or not both the old and new currencies continue to have value depends on whether the community continues to mine them, trade them, and use them.

What is an airdrop? An airdrop may occur following a hardfork and is similar to a stock spinoff (in that you receive a new asset, not in how it is taxed). For example, when Bitcoin split into Bitcoin and Bitcoin Cash, Bitcoin holders all received one “free” unit of Bitcoin Cash for each unit of Bitcoin they owned at the time of the hardfork.

To reiterate, this is taxed how?

A hardfork without an airdrop: In this scenario you did not receive any units of the newly created cryptocurrency, so you do not have any taxable income.

A hardfork followed by an airdrop: In this scenario you received units of the new cryptocurrency “for free”. Barring an exception (like the dominion and control exception detailed below), you will have ordinary taxable income equal to the fair market value of the new currency received at the time of receipt.

What is my basis in the new cryptocurrency I’ve received?

Your basis in the new coins is equal to the fair market value at the time you received the coins. In other words, if you receive new coins via an airdrop, they are taxed at the fair market value of the coin at the time of receipt. Following the receipt and taxation, your basis in these coins is equal to this same fair market value at the time of receipt because you’ve now paid tax on this amount, and the basis prevents you from being taxed on this portion again if you sell or use the coin.

Unlike a spinoff of stock, new cryptocurrency that you receive in an airdrop does not have any of the original cryptocurrency’s basis allocated to it to help offset the ordinary income recognized on receipt, whereas basis is generally allocated in a stock spinoff.

What if I can’t access my new coins?

If you held currency that was hardforked and units of the new currency were airdropped, but you do not have “dominion and control” over the new coins, you do not have taxable income. The IRS provides the following example: if the new coins are airdropped to a wallet managed through an exchange that does not support the newly-created currency such that the airdropped cryptocurrency is not immediately credited to your account at the exchange, you do not have taxable income. If you later acquire the ability to transfer, sell, exchange, or otherwise use the new coins, you are treated as having received the coins at that time and will then have taxable income.

An Example:

  • Alex owns one unit of Coin A worth $100
  • Following a hardfork, Alex is airdropped one unit of Coin B worth $50 but is not able to access it because the exchange does not yet support Coin B
  • One week later, when Coin B is supported by the exchange and Alex is able to access it, one unit of Coin B is worth $45. At this time, Alex has $45 of taxable income (at ordinary income rates, not capital gains rates). Alex’s unit of Coin B has basis of $45 (the fair market value on which ordinary taxable income was recognized).
  • Two years later, Alex sells one unit of Coin B for $60. Alex recognizes long term capital gains of $15, calculated as the $60 selling price minus the $45 basis. The capital gain is long term because Alex held the unit of Coin B for more than one year before selling it.

Can the IRS look back at any of my prior period tax returns at any time?

The IRS is limited by a statute of limitations as to how far back they can review your tax returns. The general statute of limitations is three years from the original due date of your return (or the filing date if you filed late without an extension). However, the statute gets extended to six years for “substantial understatements of income”. In general, this means that you left off more than 25% of your gross income in a given year. Additionally, if you don’t file a tax return in a given year or the IRS can prove that there was fraud involved in the filing of the return, there is no statute of limitations and the IRS can look back at that tax year forever.

Anything else new and noteworthy on this topic?

Two other items caught my eye:

  • A draft of the 2019 Form 1040 (the main form of the personal tax return), Schedule 1, indicates that you will be required to answer a question stating whether you engaged in any virtual currency transactions during the year
  • Some good news! The IRS determined that, upon sale of a unit of a cryptocurrency, you can indicate exactly which unit was sold. Why is this a good thing? Because units purchased at different times will have different cost basis, meaning you can control how much gain or loss is recognized on a sale by choosing a unit with a higher or lower cost basis as being the one that was sold. Note – in order to do so, you must document the specific unit’s unique digital identifier (e.g. private key, public key, and address) or have records showing the transaction information for all units of the specific cryptocurrency held in a single account, wallet or address. If you do not identify a specific unit, you must use the first-in, first-out method to calculate the gain or loss on the sale.

What does this mean for me?

It means that you are (or have been) potentially exposed to a source of income that did not provide you with a 1099 or any other documentation indicating that this income existed and was taxable to you at that time. This can be a scary prospect, as the IRS is on the prowl for non-compliance related to virtual currency transactions. This is especially relevant if you’ve already received a Crypto Letter from the IRS, since you’re already on their radar.

I think I’ve received airdropped coins, what should I do about it?

There are two things that need to be addressed:

  • Make sure you report income from airdropped coins received in 2019 on your 2019 tax return
  • Review your cryptocurrency investments to determine if you received airdropped coins in the past and talk to your tax advisor about whether amending your prior period tax returns is the right course of action

In conclusion…

It is up to you to determine if this situation applies to you. There are no 1099s or other tax forms filed to give you a heads up that something that took place might have triggered taxable income for you, and you have no recourse if you end up with a big tax bill or penalties and interest because you didn’t report this income. The best time to deal with this was back when it happened, but the second best time is today, so if you think you may be facing unreported taxable income due to cryptocurrency transactions, let us know, we can help you navigate this tricky and developing area of the tax code.

This is complicated and developing area of the tax code. You should always consult your tax advisor to review your specific situation before taking any action.

Want to read more about these new rules? Check out IRS Revenue Ruling 2019-24 for more information.