The Bitcoin Cash hard fork from Bitcoin on August 1, 2017 provided each Bitcoin holder with one "free" Bitcoin Cash coin for each bitcoin that they owned — at least those using wallets or reputable exchanges. While the bonus coin is worth nearly $300 today, there are hundreds of other hard forks that are worth far less and taxpayers may not even know about.
The biggest question for taxpayers is how to handle these hard forks from a tax standpoint. For example, what should the cost basis be for a new coin received from a hard fork? The IRS has provided little guidance thus far with regards to questions like these, but there are some popular opinions from accountants and other professionals.
Let's take a closer look at hard forks, how the IRS treats them and strategies for handling them (and other issues) in your tax prep each year.
What is a Hard Fork?
A fork is a change to blockchain software that creates a split in the chain. 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 fork occurs, which can have a significant impact on taxes.
There are several reasons why hard forks may occur:
- Disagreements - Cryptocurrency maintainers may disagree on the direction of the project and decide to split into two groups. For instance, the Bitcoin Cash hard fork occurred due to fundamental disagreements about how to scale the network.
- 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.
- Security Fixes - Cryptocurrency software may have inherent security vulnerabilities that need to be fixed before an attacker takes advantage of them. In these cases, a hard fork may be necessary to protect the ecosystem.
- Reverse Transactions - Cryptocurrencies that experience a hack that results in losses for its users may reverse those transactions with a hard fork. For example, Ethereum's 2016 DAO hard fork recovered funds stemming from buggy code.
When hard forks create new coins, there is usually a snapshot at a certain block number that serves as a cutoff date for receiving coins on the new chain. It's not necessary to hold the original coin after the snapshot occurs and the new coin's value will depend on market forces. While anyone can create a fork, the value of the new coin depends on its adoption.
How the IRS Treats Hard Forks
The Internal Revenue Service (IRS) has only issued a single form of guidance related to cryptocurrencies back in 2014, but it did not explicitly mention how to handle the "free" assets received from hard forks (or airdrops). Despite this lack of guidance, the tax agency has made it clear that it expects taxpayers to account for all crypto-related gains.
There are a few different interpretations:
- Immediate Taxation - Taxpayers could determine their cost basis using the market value of the forked digital asset at the point when the taxpayer receives control over the asset. The challenge with this approach is that these assets can be difficult to value before they appear on a secondary exchange or achieve a reasonable level of liquidity.
- Upon-Sale Taxation - Taxpayers could assume that the cost basis is zero when the asset was created and pay taxes on sale price of the asset when it's sold. Since there's less risk of an IRS disagreement about cost basis, upon-sale taxation is the most recommended tax treatment for hard forks until the IRS provides more guidance.
The biggest uncertainty surrounding the IRS treatment of hard forks relates to when they take control over a forked asset. For instance, taxpayers may not receive adequate notice that a hard fork has occurred and may need to actively seek out and manually claim their forked assets. It's uncertain if those that don't seek out ownership would still owe tax.
Tips to Remain Compliant
The U.S. House of Representatives petitioned the IRS to clarify the tax treatment of hard forks and airdrops, as well as outline how cost basis should be determined more broadly. It's unclear when this guidance will be issued, but many crypto traders and investors expect it to come out before April 2020 when the next tax season will go into effect.
In the meantime, taxpayers should act in good faith and work with an accountant to ensure they're properly accounting for forked assets. The safest approach is typically using the Upon-Sale Taxation approach that assumes a zero cost basis and involves the payment of capital gains or ordinary income tax — depending on the holding period — upon sale.
ZenLedger helps simplify Crypto Taxes and Accounting by aggregating transactions across multiple exchanges and wallets, calculating the cost basis and autofilling popular IRS forms, such as Form 1040 Schedule D. By automating this process in a verifiable way, you can ensure that you're paying the right amount of tax and have an audit trail in place in case of any IRS issues.
Sign up for ZenLedger today and see how easy it is to get started aggregating your transactions and maintaining an audit trail for the IRS.
The Bottom Line
Hard forks can be very valuable transactions for some cryptocurrency traders and investors. For instance, the Bitcoin Cash hard fork provided "free" coins to Bitcoin holders that are now worth nearly $300 a piece. The downside is that these transactions can make tax season more complex, especially when trying to calculate the cost basis and pay capital gains.
The best advice for most crypto users is to consult their accountant, act in good faith when paying taxes and leverage software like ZenLedger to automatically calculate gains and losses in a way that's transparent and verifiable in the event of an audit.