By Steven Singer CPA
(firstname.lastname@example.org) 510-797-8661 x 226
In my previous article, I covered how cryptocurrency is taxed. This article addresses why forks in cryptocurrency occur, the different types of forks, how they are delivered and their taxability.
In the future, I will be covering the following topics:
- If I sell cryptocurrency, how can I minimize the tax effect?
- What happens if I contribute it to a partnership or corporation? What should I look out for?
- If I want to donate it, what are the appropriate steps, and what should I look out for?
- How do I protect it from being stolen?
- What is the best way to incorporate these alternative assets in my estate planning?
- What do I need to tell my CPA and my estate attorney about where I hold it?
We advise our high net worth clients and their families on a variety of cryptocurrency issues. Most of our clients started getting into crypto currency in the middle of the 2010’s and other are now starting to invest. In most cases, our clients are either holding on to their investments or gifting them to their family members or charity.
Our primary focus is to act as their lifestyle advisor by assisting high net worth families in preserving wealth, effectively transferring wealth to the next generation, educating them and their children on how to utilize the value of achieving family objectives, and social development goals through impact investing.
In life as in business, partnerships may breakup and new ones created for a variety of reasons. The same is true in the world of cryptocurrency. In the cryptocurrency world, new cryptocurrency is created on the blockchain while older cryptocurrency may split to form new versions. In the cryptocurrency vernacular, these splits are called hard forks and soft forks. Depending on what you receive and how you receive it, it may create a taxable event. Conversely, just like an update to your existing software, receipt of the update may be tax free.
Hard Forks & Why They Occur
- Hard forks occur when:
- The cryptocurrency software diverges into two potential paths forward. As such, a new blockchain is created.
- They occur when the existing cryptocurrency code software is changed resulting in both a new and old version of the software.
- The old version is not compatible with the newer version.
- The result is there are two cryptocurrencies where only one existed before.
- A hard fork is meant to create two incompatible blockchains or tokens.
- There may be many reasons for a hard fork:
- Add new functionality like more transactions per second
- Lower transaction costs
- Correct a security risk.
- Create a new cryptocurrency (such as Bitcoin cash)
- Cause a mandatory upgrade in the blockchain so that the old blockchain cannot be used. (Ethereum classic)
- Hard forks require the consensus from the cryptocurrency holders.
- A successful hard fork requires a sufficient number of nodes that are updated to the newer version of the software protocol.
- If enough users do not update to the newer version of the software, then you will not get a clean upgrade. Examples of this phenomena were Bitcoin Unlimited, Bitcoin Classic and Bitcoin XT which were not adopted. In this case, the hard fork was worthless.
Soft Forks & Why They Occur
- Soft forks also create two versions of the software and therefore two versions of the blockchain exist.
- However, unlike the hard fork, the two versions of the software are meant to be compatible with each other. (e.g., the software is backwards compatible)
- A soft fork is meant to accomplish:
- A cosmetic change to the software
- Add functionality without tampering with the blockchain structure.
- Reduce transaction size (e.g. Segwit Protocol upgrade)
- More transactions can be processed per second
- Shorter confirmation times
- Soft forks once made cannot be reversed without initiating a hard fork.
- They are easier to implement than hard forks.
- For a soft fork to work, a majority of the miners need to be running a client recognizing the fork (MASF).
- The more miners who accept the new rules, the more secure the network is post-fork.
- If the miners keep on mining on the pre-soft fork, then the pre-fork cryptocurrency can only be used with old nodes that are not aware of the new rules. They will still be as valuable as the post-fork but using it is a little more difficult.
- If both the miners and the full nodes both accept the soft fork, it is called a user-activated soft fork (UASF)
How does one Qualify to Receive a Hard or Soft Fork?
- To qualify to receive a hard fork cryptocurrency, you must have held the cryptocurrency prior to the developers take a “snapshot” of the ledger at a specific block height.
- After the forked blockchain goes live, you can claim your new coins.
- Since soft forks do not produce any new cryptocurrency, there is nothing to do.
How are the New Cryptocurrency Delivered?
Now that your cryptocurrency has gone thru a hard fork, there are a couple of ways that you can retrieve them or how they may be delivered to you. Since there is always a risk of a scam or losing your cryptocurrency, you should always be familiar with why the fork occurred and its legitimacy, the reward vs risk and make sure the delivery is processed securely. If you do not know how to collect them safely, my advice is don’t until you do.
- An airdrop is a way to send cryptocurrency or tokens to a wallet address by distributing it to the person’s distributed ledger address.
- It is usually done for free as a part of a marketing plan.
- Its intention is increased awareness of the cryptocurrency or token which may result in new followers or traders.
- If on a third party wallet or exchange:
- Make sure it supports the fork and follow their directions.
- Always make sure you are in control of your private keys.
- Be in a wallet where you control your private keys before the snapshot occurs.
- Move your funds to a wallet new address after the snapshot but retain your private key for the old address and with a new seed phrase.
- Download the new wallet once it is live.
- Import your private key from the address you had crypto on before the fork to the new forked coins wallet.
- Discontinue the use of your original wallet address and never put funds in it again.
- Make sure a fork has transaction replay protection.
- There is no hurry to retrieve your new forked cryptocurrency. If you were in the snapshot, you can always retrieve them later.
- There is no reason to retrieve new updated currency resulting from a soft fork.
- They are backward and forward compatible so you can always use them on the blockchain.
Taxability of Splits: Soft Forks & Hard Forks
Soft forks do not create a taxable event.
- Hard Forks are taxable only if:
- You received new cryptocurrency and you have access and control of it so that you can sell, exchange, or otherwise dispose of it.
- The income you will pick up on your tax return is:
- Ordinary income measured by the fair market value of the new cryptocurrency.
- On the date that you gain access and control.
- The cost basis of the new cryptocurrency is the ordinary income that you pick up.
- The date of acquisition is the date on which you have access and control of the new cryptocurrency.
- If delivered by airdrop, generally the date and time the airdrop is recorded on the distributed ledger.
- However, if you are not able to access and control the new currency (e.g., your exchange does not support the new currency) you are not taxable until you get access and control.
- Ordinary income measured by the fair market value of the new cryptocurrency.
Check your wallets to see if you have any new cryptocurrency resulting from a hard fork. The IRS is getting very aggressive with taxpayers to make sure they are reporting this type of income.
Please let us know how you liked this article. Feel free to share it with others. Be sure to look for our other articles in this series.
As lifestyle advisors, let us know how we can assist you to achieve your lifestyle objectives. Please contact us if you are considering large transactions in cryptocurrency.