Cryptocurrency Tax Update: Impact of New IRS Guidance and Proposed U.S. Tax Rate Increase

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New Internal Revenue Service guidance on hard forks and a proposed tax rate increase on capital gains could significantly impact cryptocurrency holders.

The IRS recently clarified its position on the U.S. income tax treatment of a hard fork. A hard fork occurs when protocols on a blockchain change, causing a "fork" or splintering of the existing blockchain into two distinct ledgers. In 2019, the IRS asserted in Revenue Ruling 2019-24 that any unit of cryptocurrency received as a result of a hard fork and obtained via an airdrop was taxable to the recipient. As relevant here, an airdrop generally refers to the gratuitous, en masse distribution of (new) cryptocurrency units to existing holders. This combination of events is rare, however, and some holders may have taken a position based on the 2019 revenue ruling that a hard fork was not taxable in the absence of a corresponding air drop.

The recently released IRS Chief Counsel Advice 202114020 takes aim at that argument, stating that the receipt of new cryptocurrency units as a result of a hard fork is taxable to the recipient at applicable (individual or corporate) rates, regardless of how the new units are distributed or otherwise made available.

Another relevant tax development for certain cryptocurrency holders pertains to the IRS's position that most cryptocurrencies are considered property—not currency—for income tax purposes. A key consequence of this position is that any purchase made with cryptocurrency is taxable to the purchaser to the extent of any gain in the cryptocurrency used for payment. In contrast, a purchase using cash is not taxable to the purchaser. This can lead to unexpected results for U.S. taxpayers. If the relevant cryptocurrency has been held for at least one year, the gain is currently taxed at 23.8% for most individuals (regardless if held directly or through certain investment vehicles).

The Biden administration has recently proposed increasing the rate on capital gains for individuals from 23.8% to 43.4% for those making more than $1 million. This increase would mean significantly higher tax bills for affected holders each time cryptocurrency is used as payment (as well as converted into another digital or fiat currency or otherwise disposed of in a taxable transaction), thus raising the stakes for taxpayers.

To date, the only published guidance on the U.S. tax treatment of cryptocurrencies and other digital assets is subregulatory.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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