Virtual currency, which the IRS defines as “a digital representation of value” that does not represent the U.S. dollar or any other national currency, has gained in popularity in recent years. For some, it offers an alternative to “real currencies” like the dollar for financial transactions. For others, virtual currencies offer investment opportunities. The IRS has held since 2014 that virtual currency is “property” for the purposes of federal income tax. A recent ruling, Rev. Rul. 2019-24, offers further guidance for investors and California tax advisors alike. The ruling addresses two specific events, known as “hard forks” and “airdrops.”
What Is Cryptocurrency?
Several key features define cryptocurrency and distinguish it from other virtual currencies:
– Cryptography: Encryption protects cryptocurrency from forgery and other forms of manipulation. Many cryptocurrencies use blockchain technology, which creates a new and unique record every time a unit of currency is transferred.
– Decentralization: Cryptocurrencies are not issued by any centralized financial authority. Instead, they are created through computing processes known as “mining.” Cryptocurrency transactions are logged on databases known as “distributed ledgers,” which are maintained across multiple computer systems, or “nodes.” This also protects against forgery or falsification of records.
Taxable Gross Income
Section 61 of the Internal Revenue Code (IRC) identifies various forms of “gross income” that is subject to federal income tax. This includes “gains derived from dealings in property.” The IRS ruled in 2014 that cryptocurrency is “property” for the purpose of calculating gross incomes.
Cryptocurrency’s usefulness as actual currency remains fairly limited. Most businesses still deal in real currencies like the dollar or the euro. It is growing in popularity, however, as a form of investment. According to one prominent company providing cryptocurrency services like virtual wallets, there are almost two thousand different cryptocurrencies available. Bitcoin has the largest market capitalization, with almost $160 billion. A single unit of cryptocurrency—usually known as a “coin” or “token”—can range in value from fractions of a cent to thousands of dollars.
Some investors have made substantial amounts of money—perhaps ironically still mostly measured in dollars—investing in cryptocurrency. Just like with any investment, others have lost huge sums. Many exchanges track the price of each cryptocurrency, much like how stock or commodity exchanges track the prices of those assets. As of early November 2019, for example, a bitcoin has increased in value by over 43 percent since the beginning of the year. Buying low and selling high is therefore a common investment activity.
Income Reporting for Cryptocurrency Investors
The recent IRS ruling addresses two events that are specific to cryptocurrency, and which have remained unaddressed until now:
– A hard fork occurs when the nodes in a blockchain network make major changes to its protocols. This renders prior transactions invalid under the new protocols, so the network must upgrade the entire blockchain.
– An airdrop occurs when an exchange or other network sends free coins or tokens to a person to promote a particular cryptocurrency.
The issue addressed by the IRS involves a hard fork results in taxable income to a holder of cryptocurrency. It considered two hypothetical scenarios. In the first, a hard fork occurs and creates a new cryptocurrency, but the taxpayer only holds the original type of cryptocurrency. In the second scenario, a few tokens of the new cryptocurrency are airdropped to the taxpayer. The IRS ruled that the second scenario, but not the first, creates “gross income” as defined by the IRC.
If you have questions about taxes or tax accounting in California, the Enterprise Consultants Group’s tax accounting advisors are available to assist you. Please contact us today online or at (800) 575-9284 to discuss your case.