Deciphering the 2020 Form 1040 Virtual Currency Question

The IRS remains focused on capturing information about taxpayers who may not have reported taxable income from virtual currency transactions. The 2019 Form 1040, Schedule 1, "Additional Income and Adjustments to Income," included this question: "At any time during 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?" Additionally, the IRS Office of Fraud Enforcement recently launched “Operation Hidden Treasure,” to supplement virtual currency tax compliance efforts with those to combat related financial crime and fraud.

For 2020, the question remains on Form 1040, but it has been moved from Schedule 1 to Page 1. Even though the question remains identical, the IRS suggests via a new FAQ that the answer for 2020 may not be the same.

Background

Virtual currency is a digital representation of value (other than the U.S. dollar or a foreign currency) that functions as a medium of exchange, a unit of account, and a store of value.

Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places at the same time with no central data store or administration functionality. Bitcoin, ethereum, dogecoin, litecoin, and polkadot are all examples of cryptocurrencies.

Form 1040 Checkbox

The IRS frequently asked questions for virtual currency transactions now provides under FAQ 5 that if a taxpayer only purchases virtual currency with real currency (U.S. Dollars or another foreign real currency), then the taxpayer does NOT have to answer “Yes” to the related Form 1040 question. This change is somewhat confusing because taxpayers must still answer “Yes” for the receipt of virtual currency for free, or where the virtual currency has been received in exchange for property or services. Additionally, FAQ 5 does not apply to situations involving virtual currency forks, mining, airdrops, or exchanges from one type of cryptocurrency to another. In any case, FAQ 5 creates a new exception that is not addressed in the Form 1040 Instructions.

Virtual Currency Forks

As previously noted, the receipt of virtual currency for free triggers a reporting requirement. This dovetails with other IRS guidance that provided additional rules for virtual currency “forks.” There are two types of forks, hard forks and soft forks. Only one of these could trigger a “Yes” response on the Form 1040 virtual currency question.

Soft Fork

The first type of fork is a “soft fork.” A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger, and thus does not result in the creation of a new cryptocurrency. Essentially a soft fork is a backwards compatible update. Because no new virtual currency is created or distributed in a soft fork it will not, on its own, trigger a Form 1040 reporting requirement. A soft fork also will not generate taxable income to the taxpayer.

Hard Fork

A “hard fork” occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This type of update is not backwards compatible. A hard fork may or may not lead to the creation of a new cryptocurrency. Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger, and transactions involving the legacy cryptocurrency continue to be recorded on the legacy distributed ledger.

Hard Forks and Air Drops

Because a hard fork can result in the formation of a new virtual currency, it may result in an “airdrop.” An airdrop is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple owners. Thus, a hard fork followed by an airdrop results in the distribution of new cryptocurrency units to the legacy cryptocurrency owners. Note, however, that a hard fork is not always followed by an airdrop. If a hard fork is not followed by an airdrop, then the hard fork will not trigger a Form 1040 reporting requirement, provided that the taxpayer did not have some other triggering event. As is the case with a soft fork, a hard fork without an airdrop will not generate taxable income to the taxpayer.

But if the hard fork is followed by an airdrop, there will be a Form 1040 reporting requirement because the taxpayer received new virtual currency. This new currency is also a new asset to the taxpayer. Therefore, the taxpayer has an accession to wealth and must recognize taxable income at ordinary rates in the year of receipt equal to the fair market value of the new cryptocurrency. The taxpayer then takes a tax basis in the new cryptocurrency equal to the amount of income recognized.

Cryptocurrency from an airdrop generally is received on the date and at the time it is recorded on the distributed ledger. However, a taxpayer may constructively receive cryptocurrency prior to the airdrop being recorded on the distributed ledger. A taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency.

Reporting Dispositions of Virtual Currency

If a taxpayer disposes of any virtual currency that was held as a capital asset, then Form 8949 is used to figure the capital gain or loss. But if a taxpayer receives virtual currency as compensation for services, or disposes virtual currency that was held for sale to customers in a trade or business, then the taxpayer must report the income in the same manner as other income of the same type. Furthermore, a virtual currency disposition will trigger a Form 1040 reporting requirement.

Take Away

Virtual currency transactions are gaining in popularity. Subtle nuances to the manner in which virtual currency is acquired may mean the difference between Form 1040 reporting obligations, taxable income recognition, or no consequences at all. For more information regarding the income tax consequences to involvement with virtual currency, please contact us.