DISCLAIMER:This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax advice. You should consult your own tax advisor with regard to your particular tax position.
One of the truly enjoyable parts about being involved in cryptocurrency is all of the questions that arise when assessing the tax implications of acquiring, trading, selling, and mining cryptocurrencies. I’ve addressed some of these questions in a prior blog post, so I will use this space to talk about tax basis – in particular in the context of airdrops, forks, and mining. Briefly: in the USA, any time a cryptocurrency is sold for fiat, exchanged for another cryptocurrency, or used to purchase a good or service, a taxable event occurs. At this point, the value of the cryptocurrency must be estimated, so any gain or loss resulting from the transaction can be calculated. This gain or loss is then subject to taxation. In order to calculate this gain or loss, the acquisition price of the cryptocurrency must be known, as only the net increase or decrease is taxable.This acquisition price is generally referred to as basis. For a simple sale of a cryptocurrency into fiat, the basis is usually just the cost of acquiring the coin or token, plus any transaction fees. However, what is the basis when the holder receives the cryptocurrency by virtue of holding another cryptocurrency (airdrop or fork) or through the activity of mining?
Airdrops and (Hard) Forks. From a technical perspective airdrops and hard forks are different. The former is the free distribution of coins/tokens, usually when the cryptocurrency is new, to encourage awareness of the currency and reward participants in the community. The key concept here is that the coins/tokens are received at no cost, so it would make sense that if they were sold or traded, the cost basis of the transaction would be zero. But, is there an argument for ever assigning a basis to the received cryptocurrency? Possibly, but let’s first talk about hard forks.Hard forks, as the name implies, occur when a blockchain “splits”, resulting in a new chain, with the same block lineage as the original chain (the concept may also apply to DAGs and other approaches to DLT, but let’s keep it simple here). When this happens usually the holders of original cryptocurrency get a pro-rated amount of the new cryptocurrency. Well known examples from 2017 are the Bitcoin Cash and Bitcoin Gold hard forks off the original Bitcoin blockchain. What’s the basis of the received cryptocurrency – zero, right?
Maybe not. In some airdrop situations, and with hard forks, those receiving the new coins/tokens are holders of a predecessor/parent/original token. So if that predecessor/parent/original token drops in price when the airdrop or hard fork happens, couldn’t there be an argument made that the amount of that drop really represents the value of the newly received cryptocurrency, hence its basis for tax purposes?There are some problems with taking this approach. The first is the difficulty in measuring the amount of any price decline; the second is that anecdotal evidence doesn’t support the argument. In the equity markets stock splits usually result in the overall market capitalization of the associated company staying roughly the same immediately after the split (significant moves in price normally would happen upon announcement of the split), so the argument for allocating basis to new shares is much stronger; in fact it is commonly accepted. In the crypto markets there are too many factors at play to be able to isolate the price impact of a hard fork or airdrop.Therefore, I tell clients to assign a basis of zero to cryptocurrency received in an airdrop or from a hard fork.
Mining Activities. While a technically complicated activity, mining, from a tax perspective, is fairly straight forward. This is because broadly speaking the activity has been happening in some way, shape, or form, for hundreds of years. Blockchain miners are using compute power to generate new coins/tokens on a blockchain. To the extent that newly created cryptocurrency has value, then according to the IRS, that is income to the miner. In the case of a single individual pursuing mining activities as a business (i.e. with the goal of making a profit), that miner would report their activity through Schedule C, both the income and associated costs. In the case of a company pursuing mining, or an individual running mining activity through an LLC, then corporate tax laws would apply. If mining is done simply as a hobby (predominantly for pleasure) then income still must be reported (as “other income” on the 1040), but expenses will need to run through Schedule A as itemized deductions, with associated limitations.
That individual (operating as a hobby or business) miner might hold on to the mined coins, selling or exchanging them later. So what would be the basis in this situation? If the miner had properly reported their mining income, then the basis would be the value of the coin/token when mined.