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On Oct. 9, 2019, the IRS issued its first guidance since 2014 on the tax treatment of virtual currency. Although few retirees may now own bitcoin or other cryptocurrencies, risk-tolerant retirees may be interested in investing in virtual currency in the future.
What does this guidance mean for cryptocurrency investors?
1. Cryptocurrencies are capital assets
The IRS previously stated in 2014 that for U.S. tax purposes, cryptocurrencies are considered “capital assets,” like stocks, meaning that capital gains rules apply to any gains or losses in the value of cryptocurrency held by U.S. taxpayers.
2. Hard forks and airdrops
A “hard fork” in a cryptocurrency occurs when a blockchain ledger, used to record transactions in a cryptocurrency, undergoes a protocol change and “forks,” or splits, into two, such that a new cryptocurrency is created. Following the hard fork, transactions in the new cryptocurrency are recorded on a new ledger, while the previous ledger continues to be used to record transactions in the old cryptocurrency. For example, on Aug. 1, 2017, the ledger for bitcoin underwent a hard fork, resulting in separate ledgers for bitcoin and bitcoin Cash. Every owner of 1 bitcoin received 1 bitcoin Cash as a result of the hard fork.
An “airdrop” is a method of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. If a hard fork is followed by an airdrop, units of the new cryptocurrency are distributed to addresses containing the legacy (former) cryptocurrency, as in the case of bitcoin Cash. However, hard forks are not always followed by airdrops, and taxpayers may not actually or constructively receive cryptocurrency when an airdrop is recorded on the distributed ledger.
The IRS guidance makes clear that (1) the taxpayer does not have income as a result of the hard fork if the taxpayer does not receive units of the new cryptocurrency, and (2) the taxpayer does have gross ordinary income if, as the result of an airdrop following a hard fork, the taxpayer receives units of a new cryptocurrency. The taxpayer will have gross income at the time he or she is able to “transfer, sell, exchange, or otherwise dispose of the cryptocurrency.”
3. New tax guidance: hard forks, airdrops, basis, gain/loss, and fair market value
The new IRS guidance focuses on the tax treatment of a cryptocurrency “hard fork,” specifically whether a taxpayer has gross income as the result of a hard fork or as the result of an airdrop following a hard fork, and includes guidance on basis, gain/loss, and fair market value.
4. Unintended consequences?
The IRS guidance may create unintended tax problems for retirees who hold cryptocurrency. For instance, anyone who creates a hard fork in a blockchain can now, without notice, create new tax obligations for every holder of coins on the legacy blockchain. Similarly, if a third party airdrops a coin to an address over which a taxpayer has “dominion and control,” that taxpayer now has a potentially unwanted tax reporting obligation. Retirees who are invested in cryptocurrency should consider how to safeguard their cryptocurrency addresses. Otherwise, there is a risk that hackers will maliciously airdrop unwanted coins into accounts in order to create reporting obligations for the account-holder, or that investors will receive a new cryptocurrency from an airdrop without realizing it or requesting it. Depending on how the new currency’s value fluctuates, this may result in taxpayers having to pay income tax on an asset that was worth more when they received it than when they sell the asset.
5. Basis and income; charitable deductions
The IRS provides more details about basis and income in their issued FAQs. As above, capital gains rules apply to any gains or losses on the sale or transfer of virtual currency. However, if you transfer virtual currency from a cryptocurrency wallet or account that belongs to you, to another account that also belongs to you, then the transfer is a nontaxable event. You may also choose which units of cryptocurrency are deemed to be sold if you can specifically identify which units of virtual currency are involved in the transaction and substantiate your basis in those units. For example, you may choose LIFO or FIFO; if no method is chosen, the IRS’ default is FIFO.
If you receive cryptocurrency in exchange for performing services, whether or not you perform the services as an employee, you will be deemed to have received taxable income. The amount of income is based on the value of the cryptocurrency at the time of receipt in U.S. dollars. However, if “that cryptocurrency is not traded on any cryptocurrency exchange and does not have a published value, then the fair market value of the cryptocurrency received is equal to the fair market value of the property or services exchanged for the cryptocurrency when the transaction occurs.” Unhelpfully, the IRS does not provide any guidance in the FAQs on how to determine fair market value in this situation.
Taxpayers may also donate cryptocurrency to a charitable organization and may take a charitable deduction equal to the fair market value of the cryptocurrency on the date of donation (provided that the taxpayer held the cryptocurrency for more than one year).
6. Record-keeping
Most important, the FAQs make clear that taxpayers are required to maintain detailed records to establish positions taken on tax returns. Unfortunately, this can be difficult when dealing with cryptocurrency, particularly given the prevalence of fraudulent exchanges in this area (such as Quadriga, Bitgrail, etc.). Taxpayers will need to document all of their receipts, sales, exchanges, or other dispositions of cryptocurrency and its fair market value in U.S. dollars at the time of each transaction.
Katie Von Kohorn is a partner at Casner & Edwards specializing in trusts and estates and exempt organizations with a focus on estate planning, estate and trust administration, charitable giving and advising exempt organizations. Von Kohorn can be reached at vonkohorn@casneredwards.com.
