IRS Issues New Tax Guidance on Cryptocurrency in America
The Internal Revenue Service (IRS) has released new guidance regarding the taxation of virtual currencies (including cryptocurrencies) in the United States. This is the first time the IRS has released new guidance regarding the taxation of cryptocurrencies in five years. The last guidance issued in 2014 created a few lingering uncertainties in the cryptocurrency community. The new guidance aims to provide an updated and more clearly defined tax framework in an industry that has grown increasingly complex over the past five years.
The new guidance (released on Oct. 9) addresses several issues regarding the taxation of cryptocurrencies. Issues addressed in the new guidance include the tax liabilities created by hard forks on cryptocurrency blockchains, the methods of valuing cryptocurrency received as income, and the calculation of taxable capital gains when an American taxpayer sells cryptocurrency.
In the creation of new cryptocurrency, all of the individuals in the mining process (known as miners) need to agree on any new rules or changes to the blockchain and what comprises a valid block on the blockchain. If the miners of a cryptocurrency disagree about changing the rules of a blockchain, then it is “forked", a similar concept to a fork in the road. Forking a blockchain can result in two distinct blockchains. The new blockchain will often create a new cryptocurrency. When an individual receives units of the new cryptocurrency, it can create a potential tax liability.
The newly defined guidance says that the creation of new cryptocurrencies that are the result of a hard fork from an existing blockchain should be treated as ordinary income equal to the fair market value of the new cryptocurrency when it is received. Receiving new cryptocurrency becomes taxable once the individual has the ability to sell, transfer, dispose, or exchange the asset.
A consequence of the newly defined regulation is that third parties can potentially create tax liabilities for others by forking the blockchain of a cryptocurrency already held by individuals in what is known as an airdrop. An airdrop is the distribution of a cryptocurrency coin or token to numerous wallet addresses. Airdrops are common when an existing blockchain is forked, resulting in the creation and distribution of a new cryptocurrency.
The executive director of Coin Center Jerry Brito told Bloomberg, “One unfortunate consequence of this guidance is that third parties can now create tax reporting obligations for you by simply forking a network whose coins you own, or foisting on you an unwanted airdrop.”
Although airdrops are common, they are not required when a blockchain is forked. Airdrops are usually free and are used strategically by blockchain-based cryptocurrencies to gain attention and attract new followers. Airdrops can result in a larger user-base for a particular cryptocurrency and a wider distribution network for the new coin or token. Individuals that receive an airdrop are incentivized to participate in the success of the new coin or token as they then have ownership of the digital asset.
In circumstances where a hard fork does not result in the distribution of a new cryptocurrency the IRS states, “If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income.”
The new guidance also clarifies how American taxpayers calculate their cost basis or the fair market value of coins when they are received as income. Income generated by cryptocurrencies most often comes from either mining new coins or the sale of products and services. The IRS says that the cost basis should be calculated by summing up all of the costs spent to acquire a cryptocurrency, including commissions, fees, and other acquisition costs.
The value of a cryptocurrency purchased on an exchange is determined by the amount generated by the trade at the time of the sale plus any fees, commissions or other costs incurred when purchasing the assets. If cryptocurrencies are bought on a peer-to-peer exchange or a decentralized exchange, a cryptocurrency price index can be used to determine its fair market value. The IRS says that the price index can be a cryptocurrency or blockchain explorer that analyzes global indices that calculate the value of the cryptocurrency at an exact date and time.
When an individual sells a cryptocurrency, they can either document the specific unit’s unique digital identifier such as a private key, public key, address or records showing the transaction information for all units in a single account or address. The information that is required for record keeping when selling a cryptocurrency includes:
The date and time each unit of cryptocurrency was acquired
The cost basis and the fair market value of each unit at the time it was acquired
The date and time each unit was sold, exchanged, or otherwise disposed of
The fair market value of each unit is sold, exchanged or disposed of
The amount of money or the value of property received for each unit
The new guidance states that the IRS will not create a tax exemption for transactions below a specific price threshold, meaning that all transactions involving cryptocurrency are subject to taxation in America. Even tiny transactions such as paying for a cup of coffee. This could have a negative impact on Americans using cryptocurrency for casual purchases and has the potential to make record-keeping for tax season a time-consuming process. Cryptocurrency held for less than one year is subject to higher short-term capital gains rates. Cryptocurrency held for more than one year will qualify for lower capital gains rates.
Paying for services using virtual currency will also result in a capital gain or loss, calculated as the difference between the fair market value of the services received and the adjusted cost basis of the virtual currency used in a transaction.
The new guidance on virtual currency was released only months after the IRS began sending letters to some taxpayers that hold cryptocurrency, instructing them to ensure that their tax returns accurately reflect any gains made from the cryptocurrency.
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