Cryptocurrencies might, simplistically, be defined as virtual currencies that use cryptography to secure transactions which are digitally recorded on a widely distributed ledger. The ledger technology uses independent digital systems to timestamp and harmonize transactions. The cryptocurrencies associated with a ledger are often called “coins” or “tokens”.
Cryptocurrency can be acquired in multiple ways. This post covers only common methods, such as purchase, gift, or airdrop following a hard fork. A hard fork occurs when a ledger is subject to modifications that “break” compatibility with an earlier protocol; in other words, each leg of the fork follows different “rules” so the blockchain ledger is split into an original chain and new chain. Hard forks sometimes result in the creation of a new cryptocurrency. An airdrop is a method of distributing cryptocurrency units to the ledger addresses of individual taxpayers. Airdrops sometimes, but not always, follow hard forks. While blockchain technology is interesting, and an elementary understanding of its technological mechanics is useful, it is the tax consequences of the receipt and disposition of cryptocurrency which is the subject of this post.
The Internal Revenue Service (IRS) views virtual currencies as property. Under the Code, property will have a tax basis. A taxpayer’s basis in cryptocurrency is typically the amount spent to acquire it, inclusive of fees, commissions and acquisition costs. However, the tax bases of cryptocurrencies can also depend on the method by which it is acquired:
- If cryptocurrency is acquired for other property or services, tax basis equals the cryptocurrency’s fair market value on the date of receipt.
- If cryptocurrency is gifted, the donee follows historical property tax rules: (i) for purposes of determining gain, the donor’s tax basis carries over to the donee, plus any gift tax paid; and (ii) for purposes of determining loss, basis is the lesser of the donor’s basis or fair market value of the cryptocurrency at the time the gift was received. If the donor’s basis cannot be substantiated, the recipient’s basis is zero.
- For cryptocurrency received in an airdrop after a hard fork or as part of a promotion, tax basis equals the fair market value once the taxpayer has dominion and control over the cryptocurrency received.
Select Income Recognition Issues
Cryptocurrency from an airdrop is considered received when recorded by the ledger, but the lack of recordation may not prevent income recognition if facts suggest a taxpayer has constructive receipt of the cryptocurrency. If a taxpayer gains the right to sell or transfer a cryptocurrency, then the taxpayer almost certainly includes the value of the cryptocurrency in income when those rights arise, because those rights give the holder dominion and control over the underlying asset. The IRS has published guidance that amplifies Rev. Rul. 2019-24, where taxpayers had income without an airdrop because there was a classic accession to wealth via dominion and control over cryptocurrency.
Interestingly, taxpayers should consider what actions constitute dominion and control over cryptocurrency. Consider the receipt of cryptocurrency from an unsolicited airdrop. Cash method taxpayers usually include items providing gross income in the year of constructive receipt. Despite that, the IRS has provided that in some cases where taxpayers receive unsolicited property (otherwise includable in gross income under Code Section 61), such property is only accounted for in income if the taxpayer displays acceptance of the property by factually exercising control over the property.
Taxpayers should also consider gain recognition upon disposition of cryptocurrencies, and the application of the net investment income tax to such a disposition. As an example, assume a taxpayer realizes $100 in gross income from the time the taxpayer exercises dominion and control over chain split coins. Using the basis rules above, the taxpayer’s basis in the chain split coins is $100. The taxpayer later disposes of the chain split coins for $170. The $70 gain on disposition is an item of gross income, but may also be subject to the net investment income tax under Code Section 1411. This is because some cryptocurrency might be classified as a “commodity” under Code Section 475(e)(2)(A). In other words, the net investment income tax may apply to the disposition of certain cryptocurrencies because of the combination of Code Sections 475 and 1092.
The comments relate only to a small sample of cryptocurrency tax issues. Future guidance is expected from the IRS and individual state taxing authorities and has been specifically requested by many tax practitioners and tax practitioner groups.