IRS Clarifies How Certain Virtual Currency Transactions are Taxed

Virtual currency, cryptocurrency, digital currency – whatever you call it, the government wants to tax it. On October 9, 2019, the IRS released a Revenue Ruling and an FAQ document that provides clarity on how cryptocurrencies should be taxed. The virtual currency landscape has transformed in recent years, and because the most recent guidance was released back in 2014, taxpayers were stuck not knowing what to report. Identifying how to treat these transactions will help taxpayers better understand their filing responsibilities and can help them incorporate cryptocurrencies into their year-end tax plans. To help clients, prospects and others understand the IRS guidance, Wilson Lewis has provided a summary of key points below.

Details on the Revenue Ruling

Revenue Ruling 2019-24 covers two distinct cryptocurrency transactions: hard forks and airdrops.

• Hard Forks – A hard fork is a term that can be used in any blockchain technology. When a hard fork occurs, the blockchain diverges and can no longer communicate with the previous protocols. This creates two versions of the software: pre- and post-fork. When hard forks occur in cryptocurrencies, they effectively split the coin and the distributed ledger into two. Both versions of the cryptocurrency are valid and can continue to be bought and sold in the marketplace, each coin being recorded on its own ledger.
• Airdrops – Airdrops are when coins are “dropped” or distributed to their rightful owners. When a hard fork occurs, the newly created coins are often airdropped into the wallets of the original coin’s owners, but not always.

The Revenue Ruling clarifies when the new coins resulting from a hard fork become taxable. In alignment with established tax principles, an airdropped coin is considered received once the taxpayer can effectively control it. The guidance walks the taxpayer through two different scenarios to show how these everyday tax principles can be applied to hard forks and airdrops.

Scenario 1

A taxpayer’s cryptocurrency undergoes a hard fork and they are airdropped the new cryptocurrency.

In this scenario, the IRS states that the taxpayer should recognize ordinary income when they are airdropped the new currency. Section 61 of the tax code states that “undeniable accessions to wealth… are included in gross income.” Once the taxpayer is airdropped the currency, they have undeniable control over that asset and should, therefore, pay taxes on it.

Scenario 2

A taxpayer’s cryptocurrency undergoes a hard fork and they are not airdropped the new cryptocurrency.

The taxpayer should not recognize income following the hard fork in this instance because they were not given control of the new units of cryptocurrency that were generated. Only when the airdrop occurs will they have taxable income to report.

Once the taxpayer has control over the currency, they should include in gross income the fair market value of the coins they received. The holding period for the new currency will begin on the date they can control the coins, and their basis in the assets will be the amount they recognized as income.

Details on the FAQ Document

The Revenue Ruling only addressed hard forks and airdrops, but the IRS released a Frequently Asked Question document that goes over other cryptocurrency transactions. What we learn from the FAQ document is that cryptocurrencies are treated like any other property transaction. It addresses the following aspects of cryptocurrency transactions:

• Valuation of virtual currency units
• Basis considerations
• Holding periods
• Characters of gains and losses
• Implications of gifting or donating cryptocurrencies
• Identifying units in a transaction
• Reporting ordinary income, gains, and losses
• Recordkeeping requirements

For example, Question 35 explains that moving currencies between virtual wallets of the same taxpayer is a nontaxable event; Question 38 states that when taxpayers sell their currency, their units will be assumed to be disposed on a first in, first out (FIFO) basis unless otherwise identified; and Question 40 explains that virtual currency transactions, like any other property transactions, should be recorded on Form 8949, Sales and Other Dispositions of Capital Assets.

Questions?

The IRS releases Revenue Rulings when the tax code needs more explanation and interpretation. Although Revenue Rulings are not written into law, they are just as binding and taxpayers can confidently rely on them. The FAQs are not included in the Revenue Ruling and are therefore not binding, but they help taxpayers see how the IRS thinks through cryptocurrency transactions. If you have questions about the IRS guidance or need assistance with another tax planning or compliance issue, Wilson Lewis can help! For additional information please call us at 770-476-1004 or click here to contact us. We look forward to speaking with you soon.