In response to several calls from congress for clarity around key crypto tax issues, the IRS released Revenue Ruling 2019-24 in October of 2019, which deals with two uniquely crypto events: airdrops and hard forks.
Before we continue, if you're behind in this series you can start from Part 1 here, or just rewind to Part 4 here.
What Is A Hard Fork?
Investopedia defines a hard fork as “a radical change to a network's protocol that makes previously invalid blocks and transactions valid, or vice-versa.”
Since that definition is a bit cryptic, let’s try another version, and let’s do it in English this time? Simply put, a hard fork is a permanent split of a blockchain caused by a modification in the rules governing the chain. There are also forks that do not result in a permanent split of the chain called soft forks.
As an example, one of the most contentious hard forks occurred in 2017, when the Bitcoin blockchain forked into two chains, namely Bitcoin and Bitcoin Cash.
Imagine this scenario (inspired by true events)... On a Monday you held some bitcoin in your own Trezor hardware wallet. On Tuesday (after the Bitcoin permanent chain split), you check your wallet balance and find that you still own your bitcoin, but in addition, you received one bitcoin cash for each bitcoin you held!
What are the Tax Implications?
The Revenue Ruling essentially states that if you received new units of cryptocurrency as a result of a hard fork, you will need to recognize ordinary gross income based on the fair value of the new coin or token at the time of receipt.
There are of course further complications such as whether your wallet supported the new chain or whether you needed to do something to claim the forked coin before you exercised “dominion and control” and had “accession to wealth”. Additionally, new coins create complexity around valuation due to uncertainty around exchange support, inefficiency, and illiquid markets to name a few.
The reality is that if a popular exchange credits a new token or coin to my account (as a result of a hard fork), that I had nothing to do with, nor wanted in the first place… Do I now have to recognize the fair value of the new crypto as ordinary income?
You can begin to see why this created quite a bit of hoopla in the crypto community and probably why the February 2020 AICPA comment letter submitted to the IRS recommended to “Characterize chain split coins as unsolicited property for federal income tax purposes that are taxable if and when the recipient-taxpayer manifests acceptance by exercising dominion and control.”
What is an Airdrop?
Investopedia defines an airdrop as “a marketing stunt that involves sending free coins or tokens to wallet addresses in order to promote awareness of a new virtual currency."
For example, in exchange for signing up for a newsletter, tweeting about a token, or just for providing your wallet address, you get “airdropped” tokens, i.e. receive new tokens in the wallet address you provided.
What are the Tax Implications?
The Revenue Ruling states that if you received new units of cryptocurrency as a result of an airdrop, the taxpayer would recognize ordinary gross income based on the fair value of the new coin or token at the time of receipt.
The reality is that the majority of these airdropped tokens as part of a marketing campaign hardly exceeds a value greater than zero.
Why is this Revenue Ruling so Confusing?
“A hard fork followed by an airdrop.” Wait, What?
The Revenue ruling states that “A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.”
This seems to suggest that usually (“not always”) airdrops and hard forks happen sequentially. A point the crypto community was quick to correct! Airdrops and hard forks are two completely separate events and are not related. However it’s also fair to note as pointed out by Coin Center, these terms (i.e. hard forks and airdrops) are not straight forward, nor are they used consistently within the crypto community.
The AICPA comment letter to the IRS had this to say about it. “The AICPA concurs with Coin Center, members of Congress, and other commenters that hard forks and airdrops are terms that describe distinct and unrelated events, rather than the sequentially related events illustrated in the Revenue Ruling”.
With Ledible Tax, you can tag coins or tokens received as an "airdrop" or “hard fork” to identify and classify these items as ordinary income separately from your capital gains. This income will then be reported as “other income” on IRS Form 1040, separate from your IRS Form 8949 where your capital gains are reported from your cryptocurrency disposals.
Who said being a tax professional is boring! In our next part of this crypto tax series, we’ll continue exploring the weird and wonderful world of crypto by talking about crypto mining.
Disclaimer: This post is informational only and is not intended as tax or investment advice. For tax or investment advice, please consult a professional.