On October 11, 2019, the Internal Revenue Service (IRS) published its first ruling in five years regarding cryptocurrencies, offering guidance on taxation when these digital currencies split and asserting that they be treated as capital assets.

In Revenue Ruling 2019-24, the agency told investors that every digital currency transaction will be treated as a capital transaction for tax purposes. This includes airdrops, which are digital coins received for free as part of a “hard fork” split of a virtual currency.

Under current tax law, property and investments are generally considered capital assets, meaning the IRS views cryptocurrencies as essentially an investment asset and not as a legitimate currency and exchange medium.

Understanding the hard fork and currency splits

Hard Forks

The “hard fork” is a development that has taken place in crypto markets since the last IRS ruling on cryptocurrencies in 2014. Hard forks occur when changes to the technical aspects of the blockchain associated with a particular digital currency cause it to split and produce a second corresponding digital currency.

Airdrops

Often when these hard fork currency splits occur, backers of the new cryptocurrency will issue free tokens worth a percentage of the new currency to the digital wallets of holders of the legacy currency. This process is called an airdrop. Airdrops are used to both promote the new currency and increase its circulation in the digital marketplace. The IRS said in its revenue ruling that any investors who receive an airdropped currency must treat it as a capital asset when filing their taxes.

Investors must also maintain sufficient records to show their gains and losses on airdrops and other cryptocurrency trades and investments as delineated in the IRS FAQs, which supplement its published guidance.

Blockchain – What is it?

All cryptocurrencies are ultimately based on underlying blockchains which are essentially treated as decentralized digital ledgers that act as permanent transaction records. Each time a transaction is entered into the ledger (a process called mining that typically requires high levels of computing power), a unit of the cryptocurrency is issued to the miner, who uses cryptography and programming to securely verify and code the transaction.

Blockchains have become popular beyond cryptocurrency markets as well. Corporations and startups are expanding the use of blockchain technology to facilitate smart contracts, clear transactions more quickly, and improve their own internal recordkeeping and processes.

Changes to this overall mining process and the ledger are what lead to forks and airdrops. In what is known as a "soft fork," changes are made to the network, but it is ultimately kept intact as a lone distributed ledger.

Because soft forks in the underlying digital currency blockchains do not result in new currencies (and thus no airdrops of new tokens), investors need not worry about potential tax impacts if a token they are holding undergoes a soft fork.

Crypto Exchanges

Cryptocurrencies are also increasingly being traded on a growing number of secondary exchanges—where investors can purchase Bitcoin, Ethereum, and other cryptocurrencies—ultimately subjecting them to both the IRS’s new tax rules and developments in the underlying blockchains.

These exchanges allow investors to trade cryptocurrencies, as well as accept tokens as payment for transactions. Some of the more popular crypto exchanges include Coinbase, Kraken, and Shapeshift.

Additionally, a number of other online investing platforms (like Robinhood) have either added crypto trading functionality or announced they would soon enable it for their members.

Of particular importance to investors using these exchanges to trade in cryptocurrencies is the IRS’s ruling that any aiardrops not supported by the exchange used by the investor (and as a result not received in his or her digital wallet) would not result in a tax obligation. However, if at some point the exchange adds the new currency to its trading platform and the airdrop is received into an investor’s digital wallet, the airdrop then becomes a taxable asset.

Where Do You Report Cryptocurrency Income?
 

The IRS asks the following question prominently in the attached draft of 2019 Form 1040, Schedule 1, Additional Income and Adjustments to Income: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”  Be on the lookout for the final usable version of this form in early 2020.

Other Items to Note

One significant consequence for early adopters of cryptocurrency as a payment method results from the IRS ruling stating that any purchases made with a crypto asset in previous years must be reclassified and taxed as a capital asset sale.

The IRS also announced on July 26, 2019 that it has begun sending letters to owners of cryptocurrency who may have failed to report crypto assets, or done so incorrectly, advising them to pay back taxes. This is in addition to the agency’s previously-launched compliance education campaign aimed at helping crypto asset holders navigate their tax obligations.

As one of the most knowledgeable and well-connected tax & accounting professionals in the world, Harvey Bezozi's mission as a CPA and CFP ® is to provide concierge-level work product and service, along with seamless communication, high energy, and a super-positive attitude. Located in Boca Raton, Florida, Bezozi has been in business since 1994, and serves clients in all 50 states and internationally. More information can be found at YourFinancialWizard.com