It has been five years since the IRS issued notice 2014-21 declaring “virtual currency” as property. Since this time, the industry has continued to push for further guidance and clarification from the IRS. In May of this year, the IRS commissioner stated that further guidance was coming in the next 30 days. About 130 days later we have updated guidance in the recently issued Rev. Rul. 2019-24. The ruling isn’t changing anything from the 2014 notice, rather it is covering two unique aspects of cryptocurrency, hard forks and airdrops.
A hard fork is when a cryptocurrency undergoes a significant protocol change that results in the cryptocurrency splitting into two. The most significant hard fork occurred in August 2017 when Bitcoin was hard forked to create Bitcoin Cash. In this instance, a group of people wanted to increase the block size limit of transactions. The chain was forked to include the block size increase and Bitcoin Cash was born. If an individual held one bitcoin at the time of the fork they could claim one bitcoin cash, depending on how they held their bitcoin. For example if your bitcoin was kept on an exchange, you were at the will of the exchange to pay out the bitcoin cash, which not all of them did.
An airdrop is a distribution of a cryptocurrency or token, typically for free, to numerous wallet addresses. Airdrops have been a technique to garner attention and new users of a new cryptocurrency or token. In most instances, the user has to hold a certain coin, or create a certain wallet to be eligible to receive the airdrop.
The IRS Issues Addressed
This revenue ruling opens with two issues to address: (1) Does a taxpayer have gross income as a result of a hard fork of a cryptocurrency the taxpayer owns if they do not receive the units of a new cryptocurrency? (2) Does a taxpayer have gross income as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency?
In the first situation the taxpayer would not have gross income to report, as they did not obtain the new coins or have control over them. In the second situation the taxpayer would have gross income to report. The taxpayer would use the fair market value of the coins on the date they received them and include it as ordinary income.
Own the Keys, Own the Coins
When using cryptocurrency users have an option to custody their own assets. The user controls the private keys, and when a fork occurs they can use those keys to access the new chains coins. The IRS would consider this constructively owning the new coins and thus having ordinary income at the time of the fork.
When a user purchases cryptocurrency on an exchange and leaves the coins on the exchange’s platform, they are allowing the exchange to custody those assets. When a fork occurs, these users will only receive the forked coins if the exchange decides to pay them out. In this situation a taxpayer wouldn’t calculate income until the exchange “deposited” the new coins into the user’s account.
There have been approximately 105 forks of bitcoin to date, 74 of which are still active. In many of these cases, there was no determinable fair market value as no exchange listed them and the volume of transactions on these networks was extremely low or nonexistent. In these cases the taxpayer does not need to worry as they will have a $0 cost basis. Taxpayers will want to keep an eye out for forks coming with strong support behind them. For example, when Bitcoin Cash forked, many exchanges communicated plans to list the coin leading up to the fork. This established a price at the activation block and would require users to calculate their gross income. In some cases the newly forked coins price drops significantly as many users sell it when it lists on exchanges, since they may not have wanted it in the first place. This can cause a decline in price quickly leaving the taxpayer with ordinary income and a potential capital loss if they sell it after the price declines. Taxpayers may or may not be able to utilize the capital loss depending on their tax situation. If you are holding cryptocurrencies make sure to keep an eye out for forks and airdrops so you can plan accordingly.