How are Cryptocurrency Hard Forks Taxed?
Cryptocurrency forks like the Bitcoin Cash hard fork that occurred on August 1, 2017 are quite common in the world of cryptocurrency today. With the new IRS guidance that came out in October of 2019, it is now clear how cryptocurrency hard forks are treated from a tax perspective in the U.S. In this guide, we explore what these events are as well as the best practices for handling them for your tax reporting.
You can also learn more about how cryptocurrency is taxed in general with our Complete Guide To Cryptocurrency Taxes.
A cryptocurrency hard fork is a permanent divergence from the previous version of the blockchain. While soft forks maintain compatibility between the two chains, hard forks create chains that are incompatible with one another. Anyone that held coins before and during the fork will have coins on both chains after the hard fork occurs. This can have a significant impact on your taxes.
With this “fork” in the blockchain, one path follows the new, upgraded blockchain, and the other path continues along the old path. Generally, after a short period of time, those on the old chain will realize that their version of the blockchain is outdated or irrelevant and quickly upgrade to the latest version.
The bitcoin cash hardfork provided one “free” bitcoin cash coin for each bitcoin that you held—as long as you were using a reliable wallet or exchange. If you held 3 bitcoin prior to the hard fork, you received 3 bitcoin cash on August 1, 2017. Today, those 3 bitcoin cash are worth more than $750.
Why Do Forks Happen?
Correct Security Risks - Blockchain software may have inherent security vulnerabilities that need to be fixed before a hacker takes advantage of them. In these cases, a hard fork may be required to protect the larger ecosystem.
Add New Functionality - Cryptocurrency maintainers may want to add new functionality that’s not possible without a hard fork. For example, Ethereum’s Byzantium hard fork was a mandatory upgrade to improve privacy and scalability.
Reverse Previous Transactions - A hard fork can be used to roll back previous transactions on a blockchain. This was seen in the case with the hard fork to reverse the hack on the DAO (decentralized autonomous organization) on the Ethereum blockchain.
How Does The IRS Tax Cryptocurrency Forks?
The IRS discusses cryptocurrency forks in its new cryptocurrency guidance and ruling, 2019-24.
If a certain cryptocurrency that you are holding goes through a hard fork which “occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger”, the new forked cryptocurrency that you receive is taxed as income. Your cost basis in the newly received cryptocurrency becomes the income you recognized.
For example - If you held 2.5 Bitcoin in July of 2017, and received 2.5 Bitcoin Cash as a result of the bitcoin cash hard fork, you recognize this received 2.5 Bitcoin Cash as income at the fair market value of the bitcoin cash at the time it was received. If Bitcoin Cash was trading for $500 a piece that day, you would recognize ordinary income of $1,250 ($500 * 2.5). Your cost basis in this Bitcoin Cash becomes $1,250.
If you do not receive new cryptocurrencies after a hard fork, you will not have any taxable income. Source: A21, A22, A23, A24
Cryptocurrency Soft Forks
A cryptocurrency soft fork “does not result in the creation of a new cryptocurrency, meaning it does not result in any income.” So if your cryptocurrency goes through a protocol change but does create a new cryptocurrency - you don’t recognize any income. Source: A29
Cryptocurrency Air Drops
If you receive cryptocurrency from an airdrop (“a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses”) you recognize income on this received cryptocurrency on the day/time it was received. The amount of income recognized should be determined using the fair market value of the cryptocurrency at the time.
If you did not receive any cryptocurrency when an airdrop event occurred, you do not recognize income as you did not receive the property.
Cryptocurrency Tax Software
You can leverage cryptocurrency tax software like CryptoTrader.Tax to automatically account for all of your hard forks and airdrops in accordance with the new IRS guidance.
Simply import all of your cryptocurrency trades and transactions into the platform. In step 3 of CryptoTrader.Tax, you can add any cryptocurrency you have received as a result of an airdrop or hard fork. Simply tag these transactions as either a “Fork” or an “Airdrop” event. Every single one will be assigned with the appropriate cost basis and fair market value in USD at the time of receipt, allowing you to immediately generate your necessary tax documents with the click of a button. Using CryptoTrader.Tax’s partnership with Intuit, you can even import these reports right into TurboTax for easy tax filing or import them into your preferred tax filing software if you are a tax professional.
Disclaimer - This post is for informational purposes only and should not be construed as tax or investment advice. Please speak to your own tax expert, CPA or tax attorney on how you should treat taxation of digital currencies.