Virtual currency guidance for tax professionals
Over six years ago, the IRS published initial guidance on the taxation of virtual currency transactions. (See Notice 2014-21.) Since then, virtual currency has become more widespread, giving rise to increased IRS scrutiny and many unanswered tax questions. Thankfully, the IRS has tackled some of those questions through a Revenue Ruling and list of Frequently Asked Questions (FAQs).
New guidance on cryptocurrency transactions
In 2019, the IRS issued Rev. Rul. 2019-24, which addresses the federal income tax treatment of hard forks and airdrops, which are transactions involving cryptocurrency (a type of virtual currency that uses cryptography to secure digitally-recorded transactions). A hard fork is when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy (or existing) distributed ledger. This typically results in the creation of a new cryptocurrency on a new distributed ledger. In other words, a hard fork may produce two blockchains and two virtual currencies. For a hard fork to be successful, cryptocurrency users must agree on all upgrades to the legacy currency.
An airdrop is the mechanism used to disperse cryptocurrency units to multiple taxpayers’ distributed ledger addresses. Thus, if a hard fork occurs, an airdrop is typically used to distribute units of the new cryptocurrency to addresses containing the legacy currency. However, a hard fork isn’t always followed by an airdrop.
Generally, cryptocurrency from an airdrop is received on the date and time it’s recorded on the distributed ledger. However, this isn’t the case if the taxpayer isn’t able to exercise dominion and control over the cryptocurrency (e.g., the ability to sell, exchange, or transfer the currency). An example of this is when the cryptocurrency exchange (such as Coinbase) doesn’t immediately support the newly-created currency. Once the exchange supports the airdropped currency, the taxpayer will be treated as receiving it at that time.
Observation: A well-known hard fork occurred on 8/1/17. On that date, Bitcoin Cash (a fork of Bitcoin) was born. According to users, Bitcoin Cash was created to facilitate faster, cheaper transactions. This was accomplished by increasing the currency’s blocksize limit. At first, Coinbase didn’t support the Bitcoin Cash fork, so taxpayers weren’t able to exercise dominion and control over the new currency. However, Coinbase changed its mind after determining the currency had future market value. Bitcoin Cash is still traded on the Coinbase exchange.
In Rev. Rul. 2019-24, the IRS held that a taxpayer doesn’t have gross income under IRC Sec. 61 as a result of a hard fork if he or she doesn’t receive units of a new cryptocurrency. However, a taxpayer recognizes ordinary income as a result of an airdrop following a hard fork if he or she receives units of new cryptocurrency. The amount of income recognized equals the fair market value of the new cryptocurrency upon receipt. That amount then becomes the taxpayer’s basis in the new currency.
FAQs provide other guidance
In conjunction with the release of Rev. Rul. 2019-24, the IRS published a list of FAQs that covers other virtual currency topics, such as the tax consequences of a soft fork, receiving virtual currency as a gift, and disposing of multiple units of the same type of virtual currency. Here are some highlights.
Soft forks. Unlike a hard fork, a soft fork occurs when a distributed ledger undergoes a protocol change that doesn’t result in a diversion of the ledger. Therefore, soft forks don’t result in the creation of a new cryptocurrency. Because taxpayers are in the same position both before and after a soft fork, no income is recognized for tax purposes.
Wallet-to-wallet transfers. A transfer of virtual currency from a taxpayer’s wallet, address, or account to another wallet, address, or account belonging to the same taxpayer is a nontaxable event. This is the case even if the taxpayer receives an information return (like a Form 1099) from the virtual currency exchange or platform as a result of the transfer.
Peer-to-peer transactions. If a taxpayer receives cryptocurrency in a peer-to-peer transaction (i.e., a transaction not facilitated by a cryptocurrency exchange), the fair market value of the currency is determined as of the date and time the transaction is recorded on the distributed ledger (or would have been recorded had it been an on-chain transaction). The IRS will accept a value determined by a cryptocurrency or blockchain explorer that (1) analyzes worldwide indices of a currency and (2) calculates the value of the currency at an exact date and time.
Caution: If the taxpayer doesn’t use an explorer value, he or she must establish that the value used is an accurate representation of the cryptocurrency’s fair market value.
Receiving virtual currency as a gift. A taxpayer who receives virtual currency as a bona fide gift won’t recognize income for tax purposes until he or she sells, exchanges, or otherwise disposes of the currency (IRC Sec. 102). The taxpayer’s basis in the currency depends on whether gain or loss is recognized upon disposition (IRC Sec. 1015). For gain purposes, basis equals the donor’s basis, plus any gift tax paid by the donor. For loss purposes, basis equals the lesser of (1) the donor’s basis or (2) the virtual currency’s fair market value at the time received as a gift. The taxpayer’s holding period in the currency generally includes the time it was held by the donor.
Caution: A taxpayer’s basis in gifted cryptocurrency is zero if he or she doesn’t have any documentation to substantiate the donor’s basis. A lack of documentation also causes the taxpayer’s holding period to begin after the day the gift of cryptocurrency is received.
Donating virtual currency to charity. A donation of virtual currency to a charitable organization doesn’t result in income, gain, or loss, assuming the charity is a Section 170(c) organization. Also, the taxpayer will be eligible for a charitable contribution deduction. The deduction is generally equal to the fair market value of the virtual currency at the time of donation if the taxpayer held it for more than one year. If the taxpayer held the currency for one year or less, the deduction is equal to the lesser of the currency’s basis or its fair market value at the time of contribution.
Multiple units of the same type of virtual currency. A taxpayer who owns multiple units of the same type of virtual currency (often acquired at different times and different basis amounts) may choose which units are deemed to be sold, exchanged, or otherwise disposed of. The taxpayer must (1) specifically identify which units of virtual currency are involved in the transaction and (2) substantiate his or her basis in those units.
A taxpayer identifies a specific unit of virtual currency either by documenting its unique digital identifier (such as a private key, public key, and address) or by producing records that show the transaction information for all units of a specific virtual currency held in a single account, wallet, or address. The records must show the following information:
- The date and time each unit was acquired.
- The basis and fair market value of each unit at the time it was acquired.
- The date and time each unit was sold, exchanged, or otherwise disposed of.
- The fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.
If a taxpayer can’t identify specific units of virtual currency, they’re deemed to have been sold, exchanged, or otherwise disposed of on a First-in, First-out (FIFO) basis.
Reporting virtual currency transactions. Capital gains and losses from virtual currency transactions are reported on Form 8949 (Sales and Other Dispositions of Capital Assets). Then, capital gains and deductible capital losses are summarized on Form 1040, Schedule D (Capital Gains and Losses). Ordinary income from virtual currency transactions is reported on Form 1040, Form 1040-SS, Form 1040-NR, or Form 1040, Schedule 1 (Additional Income and Adjustments to Income), as applicable. The IRS reminds taxpayers to maintain records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the currency.
Note: The IRS is cracking down on virtual currency reporting requirements. On page 1 of the draft Form 1040 for 2020 (draft as of 8/18/20), taxpayers must answer the following question: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” (For 2019, this question was featured at the top of Form 1040, Schedule 1.) As a practitioner, make sure you’re asking clients about any virtual currency holdings and checking the appropriate box on Form 1040.
After years of anxiously waiting, many practitioners are happy to see the IRS’s additional virtual currency guidance. However, a few major questions remain unanswered, such as whether virtual currency needs to be reported on a FinCEN Form 114 [Foreign Bank Account Report (FBAR)]. Despite this, the IRS seems to be laser focused on policing virtual currency transactions. If you have clients with cryptocurrency holdings, be sure to check out the IRS’s FAQs at www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions.