On Oct. 9, the Internal Revenue Service (IRS) issued additional guidance regarding the taxation of cryptocurrency. The guidance comes more than five years after the IRS issued Notice 2014-21, the first and, until now, only official guidance regarding cryptocurrency.
Revenue Ruling 2019-24 (the Revenue Ruling) reaffirms that virtual currency is treated as property and does not constitute currency. The Revenue Ruling distinguishes virtual currencies from foreign currencies. According to the Revenue Ruling, foreign currency, unlike virtual currency, is “legal tender, circulates, and is customarily used and accepted as a medium of exchange.”
The Revenue Ruling goes on to analyze two hypothetical situations, one involving a “hard fork” and the other involving an “airdrop.” The Revenue Ruling defines a hard fork as occurring “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger” and “the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency.” It defines an airdrop as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.”
In the first situation, a taxpayer holds units of a cryptocurrency on a distributed ledger that experiences a hard fork, but the event does not result in the taxpayer receiving the new cryptocurrency via an airdrop. In this situation, the Revenue Ruling makes clear that no taxable event has occurred under Section 61 of the Internal Revenue Code (the Code) because the taxpayer “did not receive units of the new cryptocurrency.”
In the second situation, a taxpayer holds units of a cryptocurrency on a distributed ledger that experiences a hard fork, but this time the taxpayer also receives units of the newly created cryptocurrency via an airdrop. In this situation, the Revenue Ruling provides that the receipt of the new cryptocurrency via the airdrop constitutes an accession to wealth and the taxpayer, in accordance with Code sections 61 and 451, should report the receipt as ordinary income in the tax year it was received. The amount to be included in gross income is the fair market value of the new cryptocurrency, which results in the taxpayer having a basis in the new cryptocurrency equal to the fair market value.
In tandem with the Revenue Ruling, the IRS also issued Frequently Asked Questions on Virtual Currency Transactions (the FAQs). The FAQs apply only to taxpayers who hold virtual currency as a capital asset, and they are intended to expand upon the FAQs from Notice 2014-21. The FAQs contain additional new guidance for taxpayers:
- An exchange of virtual currency for other property is a taxable transaction, with the gain or loss equaling the difference between the fair market value of the property received and the taxpayer’s adjusted basis in the virtual currency exchanged.
- Virtual currency received through a trading platform or cryptocurrency exchange has a fair market value equal to what is recorded by the exchange. If the transaction is facilitated by a centralized or decentralized exchange but is not recorded on a distributed ledger or is off-chain, the fair market value is the amount the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger.
- Virtual currency received in a peer-to-peer transaction not involving an exchange has a fair market value as of the date and time it is recorded on the distributed ledger. The IRS will accept as evidence of this value the determination of a virtual currency or blockchain explorer that analyzed worldwide indices of a virtual currency and calculated the value at an exact date and time. Otherwise, a taxpayer bears the burden of establishing that its fair market value is accurate.
- Virtual currency received in exchange for property or services that is not traded on an exchange and does not have a published value will have a fair market value equal to the fair market value of the property or services exchanged for it.
- As is the rule for property, the holding period for virtual currency starts the day after it is received.
- A soft fork, defined as changes to the protocol of a distributed ledger without the creation of a new virtual currency, does not result in a taxable event.
- A donation of virtual currency may qualify as a charitable contribution.
- Transferring virtual currencies between a taxpayer’s digital wallets is not a taxable event.
- Taxpayers who own multiple units of a virtual currency with different basis amounts may choose what units are deemed sold when there is a disposition if they can specifically identify which unit or units are involved in the transaction and can substantiate the units’ basis. The unique digital identifier of a unit can be used for these purposes.
- If no units are identified, the units are deemed sold in chronological order, beginning with the earliest unit acquired (FIFO method).
Many questions remain unanswered, such as how blockchain token assets that are not cryptocurrencies will be taxed. The guidance also does not discuss simple agreement for future token (SAFT) arrangements, which generally are intended to be a nontaxable presale of blockchain tokens prior to the token becoming functional, similar to a forward contract.
The guidance, similar to Notice 2014-21, is limited to virtual currencies and makes clear that the IRS will continue to treat virtual currency as property. In addition, the guidance indicates no willingness (absent legislation from Congress) to permit exemptions for transactions with a de minimis amount of gain or loss. It also contains no discussion of how issuers of blockchain tokens should be treated for U.S. federal income tax purposes.
Taxpayers who have held or disposed of virtual currency should consult with their tax advisers regarding these rules and what the specific implications may be.