On October 9th, 2019, the IRS released some additional guidance to U.S. taxpayers about how to handle their cryptocurrency to be in compliance with U.S. IRS. tax laws. While there are several subjects covered in that release, this post will deal exclusively with Hard Forks and a mention about being able to specifically identify the cost basis of your cryptocurrency transactions (tax planning tool).
We provide a glossary of common blockchain terminology if you need to reference for definitions.
A Hard Fork is an item that some, but not all, news outlets are conflating and confusing with the discussions of “airdrops” in the IRS guidance. While the IRS document itself does contain some confusion on how and when an airdrop occurs, it is pretty clear on hard forks. When I say clear, I mean that the hard fork statements are easy to understand and follow, clarity on tax guidance may not be 100%.
If one simply looks at the sections of the IRS document that specifically relate to hard forks:
Situation 1: A holds 50 units of Crypto M, a cryptocurrency. On Date 1, the distributed ledger for Crypto M experiences a hard fork, resulting in the creation of Crypto N. Crypto N is not airdropped or otherwise transferred to an account owned or controlled by A.”
and then look at the section:
(1) A taxpayer does not have gross income under § 61 as a result of a hard fork of a cryptocurrency the taxpayer owns if the taxpayer does not receive units of a new cryptocurrency.”
There is not a tax event for a hard fork except for specific situations. I will explain how I come to that conclusion.
To keep things simple, I am adding the assumption that situation 1 crypto M is being held in a single wallet specifically designed for only holding that cryptocurrency. This is to help isolate any other complications with holding cryptocurrency in other ways.
The fact states that this hard fork does not “transfer to an account owned or controlled by A”. That makes sense, I won’t see that new cryptocurrency in my wallet that is designed for only holding crypto M. That means no constructive ownership, meaning no tax consequence, just as the holding states in the first part of its sentence. It would have been clearer if the holdings statement just did not continue with the “if the taxpayer does not receive units of a new Cryptocurrency.” That seems to belong to the IRS’ statements conflating airdrops and hard forks where they seem to believe that airdrops only follow hard forks. I think it would have also been better to keep that additional statement in their clarification about cryptocurrency held on exchanges or in other third-party custody where a hard forked cryptocurrency might be added without your involvement.
The open item I see people struggling with is in the last part of the holdings statement about “not receiving new units of a cryptocurrency”. You have the private key associated with that new cryptocurrency, so you received Crypto N didn’t you? And if not received, then definitely control right? Your private keys of Crypto M = access to your coins for Crypto N. Are you now responsible for income from a new coin that you may not even be aware of existing?
I don’t believe that all of these questions are necessary because situation 1, as presented by the IRS, states that Crypto N has been created by the hard fork AND is not transferred to an account owned or controlled by A This last part of the statement is Crucial for the “holdings” that they also present. In a hard fork Crypto N IS NOT Transferred to an account owned or controlled by you. You have to get a new wallet to claim Crypto N with your Crypto M private key.
While not specifically stated in this IRS document, because a person has not yet claimed their hard forked cryptocurrency, “Crypto N” in this instance, they do not have constructive ownership or control over it and therefore owe no tax on it. Specific situations where there is a tax consequence for a hard fork? Once they claim it with their private key, or hold it in a wallet that ends up claiming that cryptocurrency automatically for them, or hold on an exchange that places it into their account – that is when they have constructive ownership and an income tax liability is created.
If, as the IRS states that there is no tax consequence until an exchange claims new coins for you, then shouldn’t it follow that you have no tax consequence until you individually claim the coins too? Remember this is for hard forks only.
But, what if I don’t check my multicurrency wallet or my exchange account and I miss the addition of these newly created hard forked coins?
I would use an example from traditional investing. Because traditional brokerage accounts are very regulated, dividend payments and other income producing events are recorded for you and reported to the IRS automatically, regardless of whether you log into your account or look at your statements or follow the news for that investment that threw off some extra income to you. You owe the taxes on that whether you know about them or not.
This might not be a popular statement to make, but cryptocurrency is no different as far as potentially unexpected income events. Just like owning your keys = owning your cryptocurrency means you don’t have a bank to recover your cryptocurrency if you lose your private keys; owning cryptocurrency currently requires one to pay attention to what is happening with respect to it and the potential tax consequences associated with it.
Being your own bank means you have to do all of the jobs that you normally pay the bankers to do and that includes recording/reporting/withholding taxes.
If someone doesn’t want to have to deal with all of that, then put your coins on an exchange. But understand that you will still have to pay attention to any new coins that show up from forks or airdrops. You won’t have to do any of the homework on how/when they are happening – but there is a fee for this convenience and foregoing direct custody of your coins.
If that is still too much, then stay away from cryptocurrency and use a traditional brokerage or bank account that is still in existence that will do everything for you – for a fee and also foregoing direct custody of your money.
One more item about taxes is that in the IRS new FAQs they clarify in their Answer 36 that you can use specific identification for tax reporting purposes. That is where you can pick the specific purchase of a cryptocurrency to match with a specific sale of the same cryptocurrency.
The IRS Answer 37 clarifies that you must keep impeccable records to claim specific units of virtual currency. “(1) the date and time each unit was acquired, (2) your basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) 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.” Because YOU are the record keeper, I would recommend that you take screen captures of transactions as they happen, making sure that the time is included with the date! Having a timestamped record of your trade details will be the strongest way to support any questions that ever come up with your tax reporting.
Specific Unit Identification is a very useful tax planning tool when it comes to any volatile investment but remember that because tracking it properly and matching purchases/sales requires extra work; if you don’t do that tracking yourself it could be more expensive, compared to the more traditional FIFO (First In First Out), to get someone to do your taxes using that method.
Bottom line for hard forked coins and all tax consequences is:
Own your keys, Own your crypto, Know your crypto.
For those that own their private keys, you are your own bank, broker and record keeper along with all of the associated responsibilities.
Disclaimer: The information contained in this post is not meant to be used as tax advice. Tax advice should be obtained from a tax professional that can speak with you about your specific situation and circumstances.
|Peter holds an MBA, and CMA, CITP, CGMA certifications. He is currently CFO at Blockspaces, LLC. Blockspaces offers, an “ideation lab” for individuals that are interested in enterprise related blockchain and community support for education in the blockchain and cryptocurrency space. He has recently held Senior Financial positions in both America Tool & Mold and Dosatron, both located in Clearwater, FL. Peter has spent his career helping organizations build their businesses with financial insights using a focus on using technology to increase efficiency and gain competitive advantages.|