Forks, airdrops, and like-kind exchanges
Tis impossible to be sure of any thing but Death and Taxes — Christopher Bullock (1716)
This tax season millions of Bitcoin owners will face a great deal of uncertainty when filing their 2017 US tax return. The last time the IRS issued guidance to US taxpayers in regard to Bitcoin was 2014, and it clarified a number of tax issues that were unclear at the time. For example:
- For tax purposes, is Bitcoin to be treated as a currency or as property? The IRS ruled that it is to be treated as property, saying “[g]eneral tax principles applicable to property transactions apply to transactions using virtual currency”. An example of the tax principles that apply to property are capital gains treatment. For instance, if Alice were to buy 10 bitcoins at $1,000 each for a total of $10,000, then later sell them all for a total of $50,000, the $40,000 difference would be treated as a capital gain. If Alice had held those Bitcoins for over a year, she would qualify for long-term capital gains treatment at a preferential tax rate (between 15% and 23.8%, depending on her total income). If she held them for less than a year, they would be taxed at the higher short-term capital gains rate (her ordinary income tax rate, which could be as high as 39.6% in 2017, depending on her total income).
- Are the proceeds of Bitcoin mining to be treated as income? They are and the bitcoins received from mining are subject to the “self employment tax”. The basis of the newly created bitcoins is their US dollar value at the time they were mined.
- Is payment of a good or service with bitcoins to be treated as a taxable event? It is. For instance, if Bob were to purchase 2 bitcoins at $1,000 each, then use these bitcoins to purchase a bicycle for $5,000 when the price of Bitcoin had risen to $2,500, he would owe capital gains tax on the net gain ($3,000) in the year the purchase was made.
With the pace of innovation of cryptocurrency markets, it is unsurprising that since the IRS issued its 2014 guidance, several new tax issues have become important for which no new guidance has been provided.
The size of the cryptocurrency market ballooned in 2017 as millions of US taxpayers added bitcoins and other cryptocurrencies to their portfolios. A survey of 2,000 people by research firm Qualtrics showed that 57% of them had realized some gain on cryptocurrencies in 2017, while tax company Credit Karma reported that of the 250,000 people who used their software to file in 2017, only 100 reported a taxable gain from cryptocurrency sales.
Worryingly, it seems that many taxpayers are unaware of the rules that dictate their tax obligations in regard to cryptocurrencies. The aim of this article is to provide some thoughts on three of the most important tax issues facing US taxpayers who have cryptocurrency gains in 2017. I will explain how previous guidance can be applied to these issues and when the previous guidance is insufficient for resolving an issue, I will walk you through how the IRS is likely to expect the issue to be handled based on guidance provided for similar assets. Before I proceed with an examination of the aforementioned tax issues, it will avail us to have a glossary of terms to make the examination as precise and unambiguous as possible.
- Blockchain: A publicly viewable database of all the transactions that have occurred for a given cryptocurrency (e.g., the Bitcoin blockchain), recorded in chronological order. The transactions are grouped into “blocks”, typically of limited data size, that are periodically added to the database, with each new block referencing the prior block that was added. Hence a chain of blocks, or “blockchain”.
- Bitcoin network: A peer-to-peer network of computers, often called nodes, which each keep a copy of the Bitcoin blockchain and which independently verify the validity of new blocks before adding them to their own copy of the blockchain.
- Bitcoins: Digital tokens that are transferrable on the Bitcoin network by the submission of a valid transaction to the nodes on the network. It is important to note that the concept of bitcoins as transferrable tokens is an abstraction built upon the blockchain. The blockchain, being a database of all the past bitcoin transactions, allows for the creation of a ledger system. The ledger records which bitcoins are assigned to which “bitcoin addresses” (a bitcoin address is roughly analogous to a bank account number that has an associated balance).
- Private keys: The bitcoins associated with a bitcoin address can only transferred by the person who possesses a private key for the address. The private key is a unique piece of data that cannot be guessed or forged by another person. To transfer bitcoins from one address to another, the possessor of the private key must digitally sign a transaction with their private key before submitting the signed transaction to the Bitcoin network.
- Dominion ownership: A person who possesses the private key for a bitcoin address has exclusive control over the associated bitcoins. They are therefore the owners of these bitcoins. The possession of the private keys of one’s bitcoins is the strongest type of ownership a bitcoin owner can have because they have dominion over their own keys. This type of ownership will be labeled “dominion ownership” for the purposes of this article.
- Custodial ownership: An owner of bitcoins can transfer their bitcoins to a custodian, such as a cryptocurrency exchange like Coinbase, if they do not feel confident about maintaining the security of their own private keys or if they wish to trade their bitcoins for dollars at some point in the future. The custodian will keep those bitcoins on their own addresses for which they have their own private keys. This form of ownership will be referred to as “custodial ownership” for the purposes of this article.
Perhaps the most important and complex tax issue that arose in 2017 was the forking of Bitcoin. A fork is the creation of a new cryptocurrency (e.g., NewCoin) by cloning Bitcoin in a way that the blockchains of the two cryptocurrencies are identical up until the “snapshot date”. Once the blockchain for the new currency has been created and its network is operational, anyone who had private keys for their bitcoins would then be able to control an equivalent number of newcoins on the NewCoin network. For example, if Alice had dominion ownership of 17 bitcoins prior to the NewCoin fork, she would then control 17 bitcoins and 17 newcoins after the fork was completed. Dominion ownership would give Alice the ability to transfer her 17 newcoins on the NewCoin network once it became operational. It is important to note that if Alice had custodial ownership of her bitcoins, she would not have the ability to transfer or sell her 17 newcoins unless the custodian of her bitcoins decided to support NewCoin.
The most prominent fork in 2017 was the creation of “Bitcoin Cash” (BCash) on August 1st, 2017 (its snapshot date), a currency that commands a market capitalization of approximately 11 billion dollars at the time of writing. Several other forks have taken place since then, creating currencies such as Bitcoin Gold (750M market cap), Bitcoin Diamond, Super Bitcoin and Bitcoin Private. Many of these forks have tiny capitalizations relative to Bitcoin and are not even tradable on US exchanges. BCash, for example, was not supported on the largest US exchange (Coinbase) for several months after its creation and Coinbase still does not provide support for Bitcoin Gold and other less prominent forks.
The most important tax question related to forks is whether they represent a taxable event or not. There are several reasons to believe they should not be treated as taxable events.
- Due to Bitcoin’s open source nature and the ready availability of its blockchain, anyone can fork Bitcoin at any time. If it were the case that forks were taxable events then a programmer in Korea, for example, could create a trivial fork of Bitcoin with little marketable value and thus cause a taxable event for millions of US taxpayers who owned bitcoins.
- For taxpayers who have custodial ownership of their bitcoins, they may never be given access to the newly forked coins. If forks were taxable events then taxpayers may be saddled with a tax burden and no attendant income to pay that burden.
- Even for taxpayers who have dominion ownership of their bitcoins, the newly forked coins they own may not be tradable on any licensed US exchange, or even on any exchange at all.
- Dominion owners of bitcoins may choose not to use or transmit their forked coins due to the risk that use of these new coins might expose the keys of their much more valuable bitcoins (the keys to both coins are the same). There is also a cost to the taxpayer in obtaining sufficient knowledge of the newly created coin to even be able to transmit it. If forks were treated as taxable events, the IRS would be forcing taxpayers to risk the security of their possessions to produce funds to pay for their new tax obligation.
In short, if the IRS were to treat forks as taxable events it would cause chaos for millions of US taxpayers who would need to keep abreast of every fork that happened and who may not even have a way of selling the forked coins to pay their tax obligation.
Furthermore, the 2014 IRS guidance directed US taxpayers to use the rules applicable to property when determining the tax burden resulting from the sale of cryptocurrencies. Under the previous guidance, then, it would be reasonable to consider the forking of Bitcoin as akin to a property owner splitting their house into two separate condos — their prior ownership of the house would give them ownership of both condos after the split had occurred, but the split itself would not be a taxable event.
It should be noted, however, that although the most reasonable policy would be that forks are not taxable events, the IRS has, in the past, chosen policy positions that can leave taxpayers with tax burdens they are unable to pay. A common example is when a company grants an employee NSO stock options that the employee exercises at some theoretical gain, but for which there is no liquid market to sell the resulting shares. During the dot-com bubble of 2000, many people were bankrupted after exercising options that were granted by companies that subsequently became worthless:
Many of these workers now owe far more in taxes than their stock is worth. Former Cisco engineer Jeffrey Chou, 32, owes $2.5 million in taxes on company stock he purchased last year that has since withered in value. Chou figures that if he were to sell everything he owns, including the three-bedroom Foster City, Calif., townhouse that he shares with his wife and 8-month-old daughter, the family still could not pay the bill.
If we proceed under the assumption that the IRS will accept the most reasonable position for forks — that they do not represent taxable events, but are akin to the splitting of a property into two properties — we must then consider the question of what tax basis should be assigned to the two cryptocurrencies after the fork has taken place. Luckily there is a similar tax situation known as “spinoffs” from which we can infer guidance for basis allocation. Under a typical corporate spinoff, one company, such as Ebay, will split into two companies, such as Ebay and Paypal, each with its own tradable security listed on a stock market. According to William Mitchell, of the Spinoff and Reorg Profiles report:
Typically, in the United States, shareholders in distribution-type spinoffs are taxed on gains or losses in the tax year in which they sell the shares. To calculate tax basis in the spinoff and parent, the shareholder must allocate his basis in the purchase of shares in the original company pro rata across the two resulting companies, based on the relative fair market values of the parent and spinoff immediately after the separation.
When a spinoff occurs, it is often the case that the original corporation will provide guidance on the fair market value of the newly created corporate entities so that taxpayers are able to assign a cost basis to the associated securities. In the case of a fork, there is no entity to provide guidance and the taxpayer must determine a fair market value on their own. There are two methods of assigning a basis that are likely to be viewed as reasonable by the IRS:
- A portion of the basis of the original bitcoins is assigned to the forked newcoins based on the taxpayer’s best assessment of the relative values of the two currencies after the fork has occurred. The taxpayer may, for example, measure the average price ratio of Bitcoin to NewCoin on a cryptocurrency exchange for the first week after NewCoin is listed and use this ratio as a means for apportioning basis between their bitcoins and newly created newcoins.
- In the face of several forks, the taxpayer may choose a simpler path and keep the original basis for their bitcoins and assign a basis of $0 to their newcoins.
In either case, the total basis for the coins must equal the basis of the bitcoins prior to the fork.
Finally, if we are to follow the logic of corporate spinoffs when considering forks then the holding period of the forked newcoins would be inherited from the original bitcoins prior to the fork for the purposes of qualifying for long-term capital gains treatment.
On August 1st, 2017, Alice, who hitherto had dominion ownership of five bitcoins that were purchased on March 1st, 2017, for $1000 each, then became the owner of five BCash tokens after the BCash fork. Alice chose to record the basis of her BCash tokens as $0 and keep the original basis of $1000 for her bitcoins. Alice decides to hold both her bitcoins and her BCash tokens through the rest of 2017 and because forks are not taxable events, no tax is owned on her bitcoins or her BCash tokens during 2017. On March 2nd, 2018, Alice decides to sell her BCash tokens for $900 each. Because the holding period of her BCash tokens is inherited from her bitcoins, as is true with a corporate spinoff, Alice’s sale qualifies for long-term capital gains treatment. Thus, Alice owes long-term capital gains tax on 5 * ($900-$0)=$4,500 and the capital-gains rate is set based on her total income.
An airdrop is the the giving of a cryptocurrency by some entity, such as a foundation that created the currency, to a recipient based on the recipient’s proof of ownership of another cryptocurrency; the proof is provided using an unforgeable digital signature. For instance, on June 27th, 2017, the Stellar Development Foundation gave “lumens” (the token of the Stellar cryptocurrency) to anyone who could prove they owned bitcoins. The amount given in an airdrop is typically proportional to the number of bitcoins the recipient can prove they own.
The critical difference between airdrops and forks is that when a fork occurs, an owner of bitcoins will instantly own the newly created coins by the mere fact the keys to the two coins are identical. When an airdrop occurs, the owner of bitcoins must perform some action to prove they own their bitcoins before receiving the airdropped coins.
The receiving of a new cryptocurrency in an airdrop is likely to be treated similarly to the discovery of “treasury trove” income. In 1969, in the landmark case of Cesarini v. United States, the US District Court for the Northern District of Ohio ruled that the proceeds of a treasure trove (the unexpected discovered of cash) should be included in the taxpayer’s gross income in the year it was discovered. Furthermore, the court also ruled that such income does not qualify for preferential capital gains treatment.
Given that an airdrop is likely to be treated as income, the basis for the airdropped currency would be the marketable dollar value of the cryptocurrency at the time it was received. Any subsequent appreciation or depreciation after the acquisition of the cryptocurrency would then be treated as a capital gain or loss from the original basis.
On June 27th, 2017 Bob receives 10,000 lumens based on a digital signature he provides to the Stellar Development Foundation proving that he owns 2 bitcoins. At the time that he receives the 10,000 lumens, their total marketable value is $300. 7 days later, Bob sells those lumens for $250.
- Bob will receive income in 2017 of $300 from the acquisition of the 10,000 airdropped lumens.
- The basis of the 10,000 lumens is $300.
- Bob can claim a $50 short-term capital loss in 2017 based on the sale of the lumens for $250 ($50 less than their basis).
With the proliferation of new cryptocurrencies in 2017, several exchanges, such as Bittrex, Binance and ShapeShift.io, began offering trading between cryptocurrency pairs such as BTC-BCH and BTC-ETH. Given that the currencies themselves are to be treated as property, according to the 2014 IRS guidance, some tax experts wondered whether trades between cryptocurrencies would be considered “like-kind” exchanges (also known as 1031 exchanges). A like-kind exchange is the disposal of one kind of property and acquisition of an equivalent kind so that the disposal of the first property (typically real-estate) does not immediately incur a tax liability (it is deferred until the second property is sold for US dollars). On June 10th, 2016, in a letter sent to the IRS, The American Association of CPAs pressed for guidance on whether exchanges between cryptocurrencies were a like-kind exchange:
[I]f there are particular factors that distinguish one virtual currency as like-kind to another virtual currency for section 1031 purposes, the IRS should clarify these details (e.g., allowing the treatment of virtual currency held for investment or business as like-kind to another virtual currency) in the form of published guidance.
While the IRS has not issued further guidance, the issue was taken up by Congress in 2017. Section 13303 of the recently passed Tax Cuts and Jobs Act amended IRC Code section 1031 to change the wording from “property” to “real property” (thereby excluding “virtual property”). The obvious implication is that the ability to treat cryptocurrency-to-cryptocurrency trades as like-kind exchanges was, at best, a loophole that Congress wished to eliminate. While this change does not apply specifically to 2017, it does imply that transfers between cryptocurrencies will not be considered like-kind in 2018 and beyond. To treat such exchanges as like-kind in 2017 would be attempting to use what is considered a loophole and is likely to be rejected by the IRS. Furthermore, if the taxpayer does attempt to treat cryptocurrency to cryptocurrency trades as like-kind exchanges, the burden of filing them as such is inordinately high. Like-kind exchanges must be filed on form 8824 and must be filed for every trade between cryptocurrencies, which could be costly if a CPA is employed for the task.
In light of the amendment to section 1031 it would be prudent for taxpayers to consider trades between one cryptocurrency and another as a taxable event, even in 2017. Given previous guidance to treat cryptocurrencies as property, the taxable event would represent a capital gain (or loss), with the gain (or loss) calculated as the dollar value of the cryptocurrency that was disposed of, at the time of the exchange, minus its original basis.
The following example assumes that trades between cryptocurrencies are not like-kind exchanges, as argued above.
Suppose Alice buys 10 ETH tokens at $50 each on June 15th, 2017. Three months later, Alice trades her 10ETH for 1 BTC when the dollar value per ETH token is $300. The net gain will thus be 10 * ($300-$50) = $2,500. It will be a short-term capital gain as the 10 ETH were held for less than a year.
Millions of US taxpayers became owners of cryptocurrencies in 2017 and many of them used or exchanged these assets without realizing that doing so incurred a tax liability. Almost any exchange of a cryptocurrency, whether it be for dollars, another cryptocurrency, or for goods and services, is a taxable event and requires the reporting of the attendant gain or loss.
While the IRS provided general guidance for the tax treatment of cryptocurrencies in 2014, it did not anticipate many issues that became significant in 2017, such as forks, airdrops and like-kind exchanges. For these issues, US taxpayers must infer reasonable guidelines to follow when filing their taxes. Unfortunately, making a mistake when inferring these guidelines can result in penalties and interest paid on an unpaid tax liability — the IRS has three years to disagree with a position taken on how to handle one’s cryptocurrency taxes and six years if the income received from cryptocurrency gains is more than 20% of your income.
The three issues raised in this article — forks, airdrops and like-kind exchanges — are complex and may require a detailed analysis to resolve correctly, especially for taxpayers who had many cryptocurrency trades in 2017. Although taxpayers can file for an extension to delay the submission of their tax return until October 15th, 2018 (rather than April 17th), taxpayers are still expected to pay the correct amount of taxes by April 17th (underpayment on April 17th will still result in penalties and interest, even if an extension is filed). Given the complexity of the issues raised, it would be advisable for US taxpayers to seek professional advice when filing their taxes if they have taxable events related to cryptocurrencies in 2017. It is my hope that with the analysis in this article, and with professional help, taxpayers who faced the aforementioned tax issues will be able to successfully navigate their 2017 US tax returns.
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Thanks to Michael Flaxman and Daniel Coleman for proofreading this article and to Luke Gabrieli for his help with photoshop. Thanks especially to Laura Walter for her very detailed feedback. Laura is a CPA who specializes in cryptocurrency tax issues. She is incredibly thorough and detail-oriented and I highly recommend her to any US taxpayer who is unsure of how to handle their cryptocurrency tax issues (the views and any errors in this article are my own and her involvement should not be construed as an endorsement).
I am not an accountant and the opinions expressed in the article above may contain errors. Please consult with a CPA before deciding how to handle your cryptocurrency taxes.