For the first time since 2014, the IRS has released guidance addressing the taxation of cryptocurrency. In Revenue Ruling 2019-24 and an updated FAQ on virtual currency transactions, the IRS has provided guidance on the taxation of hard forks, airdrops, and provided details on the accounting and calculation of gain/loss on virtual currency transactions. The new guidance expands upon prior guidance contained in Notice 2014-21 by adding the agency’s first revenue ruling on the topic and expanding upon the sixteen original questions by adding twenty-seven new questions and answers.
Revenue Ruling 2019-24 addresses two key issues facing holders of virtual currencies: how to tax hard forks and airdrops resulting from hard forks. The revenue ruling provides clarification, background, and related terminology on these two opaque tax issues. It provides taxpayers with guidance on how to calculate basis and when to recognize income with regards to hard forked cryptocurrencies and cryptocurrencies received through an airdrop because of a hard fork. The terminology used by the IRS is not necessarily consistent with commonly accepted industry terminology and may prove difficult for taxpayers trying to apply this guidance to real world situations. Furthermore, it is not clear whether the policies outlined in the revenue ruling would apply to all airdrops or just those airdrops following a hard fork.
According to the revenue ruling, a taxpayer does not have gross income as a result of a hard fork of a cryptocurrency if the taxpayer does not receive new units of cryptocurrency. However, if a taxpayer receives an airdrop of a new cryptocurrency after a hard fork then the taxpayer has gross income. A taxpayer’s basis and gross income is both determined and recognized when either the transaction is recorded on the distributed ledger or the taxpayer is able to exercise dominion and control over the new cryptocurrency. Thus, a potential delay in recognition would occur when cryptocurrency held on an exchange undergoes a hard fork with an airdrop and the exchange delays the issuance of the new hard forked cryptocurrency.
The updated FAQ expands on the analysis provided in the revenue ruling. Some of the key takeaways from the updated FAQ are:
- Cryptocurrency is defined as a type of virtual currency that digitally records cryptographically secured transactions on a distributed ledger, such as a blockchain. This definition further clarifies a distinction between transactions that are recorded directly on a distributed ledger versus those that are not recorded or occur directly on a distributed ledger as “on” and “off-chain” transactions, respectively. For example sending a digital asset directly to a friend’s hardware wallet would be an “on-chain” transaction while a trade that occurs and settles on a digital asset exchange would an “off-chain” transaction.
- A taxpayer’s US Dollar cost basis in their digital assets equals the spot price of the digital asset at the time of acquisition, but also includes fees, commissions, and other acquisition costs.
- The USD value received on a disposition or sale of a digital asset and the taxpayer’s cost basis in a digital asset should be determined using the FMV at the exact date and time the acquisition and subsequent disposition of the digital asset occurs. If the price at the exact date and time of the transaction is not provided by an exchange or otherwise available from price sources such as a blockchain explorer, the taxpayer must establish the value used is an accurate representation of the digital asset’s FMV at the time of disposition or sale.
- The taxpayer may specifically identify units of digital assets disposed, sold, etc. provided the taxpayer can identify or substantiate the specific basis of the units disposed or sold.
- If a taxpayer cannot or does not specifically identify the units, sold, exchanged, or otherwise disposed, they must utilize first-in, first-out (FIFO) accounting.
- A hard fork occurs when a digital asset undergoes a complete protocol change, permanently diverting from the previous history of the distributed ledger or blockchain. However, income is only recognized if a taxpayer receives and has dominion over a new digital asset from an airdrop resulting from a hard fork.
- The ruling clarifies income recognition, cost basis determination, holding period and other related questions if a digital asset is received/used as payment for providing/paying for a good or service, donated to a recognized charity, or received as a gift or inheritance.
While the new guidance provides much needed clarity, there are many tax issues for holders of virtual currencies that are still not addressed. Furthermore, some of the guidance provided will prove difficult for taxpayers to follow in real world situations. Taxpayers with digital asset activity, especially those on extension and that have yet to file and those who have received letters regarding their cryptocurrency holdings from the IRS, should consult with their tax advisors as soon as possible. Positions taken on yet to be filed tax returns may need to be reconsidered and any amendments of prior year returns on account of the IRS cryptocurrency letters should be done prior to the start of any formal audit in order to avoid potential penalties.