Blockchain Finance

Understanding Cryptocurrency Forks and Tax Liabilities

The key to reaping your cryptocurrency investment rewards is understanding what it is and how it works. New investors will find that digital currencies have numerous nuances that take time to master.

Having a basic grasp of how cryptocurrencies operate is the first step in discovering their potential. You will need to learn about concepts like forks, as well as the tax obligations on crypto transactions.

What are Forks?

Let’s start by defining the building blocks of cryptocurrencies—blockchains. A blockchain is a ledger of cryptocurrency transactions made up of blocks, where transactional information is updated chronologically. 

A fork happens when a cryptocurrency’s blockchain fundamentally changes. Blockchain networks are based on open-source software, which means they can be modified to achieve different objectives by anyone with the knowledge. When crypto miners make changes to a blockchain, they will need to decide whether to continue within the existing ecosystem or create a new one; this is how new cryptocurrencies are formed.

Soft Forks

In a soft fork, changes are made to the blockchain’s software protocol after the fact. However, the new blockchain still recognizes old nodes as valid. Simply put, a soft fork allows backward compatibility. 

Introducing a new transaction type to a blockchain is an example of how a soft fork works. The sender and receiver and crypto miners updating these transactions will need to understand this new transaction type. Old clients of the crypto will see the new transaction type, but new trades will have to conform to the latest software protocol.

Hard Forks

Hard forks entail more radical changes to a blockchain network’s software protocol. The nodes in the new version of the software protocol are incompatible with the old ones, meaning clients and miners on the old version have to upgrade to the latest version of the blockchain. 

If all parties are not in agreement with the changes and some insist on continuing with the old protocol, a new cryptocurrency can result. An example of a hard fork is Bitcoin Cash, formed by Bitcoin.

Cryptocurrency and the IRS

While people complete transactions using Bitcoin and other cryptocurrencies, the Internal Revenue Service (IRS) does not consider virtual currencies legal tender. This is also the case in countries other than the US. However, for tax purposes, the IRS views digital currencies as property, in the same way, it views stocks and other money market investments. 

If you were given cryptocurrency or bought it and sold it after it increased in value, you enjoyed a gain and are, therefore, liable to pay capital gains tax. You won’t be required to do so if you suffered a loss, but this loss needs to be clearly documented in your filing. 

When a fork happens, the value of the cryptocurrency involved tends to experience increased volatility. The change in value will also be reflected in the taxes the IRS will expect from your crypto transactions. Make sure to keep tabs on all of these expectations. 

Tax Liabilities

Cryptocurrency mining is an income-generating activity for which miners are usually paid in crypto. As a miner, you need to include such income in your taxable income when filing your returns. If you owned bitcoin or altcoin and disposed of it at a higher value than you acquired it, you have enjoyed a capital gain. The IRS will expect you to declare this gain and pay the associated tax.

To ensure that you are operating legally, you will need to keep clear records of your cryptocurrency transactions. It is required to fill the same Form 1099-B you get when you buy stocks. This form shows the value of crypto when you bought it and its current value to determine if there was a gain.  

If your crypto investment exceeded $20,000 or you did more than 200 transactions through the year, you will need to fill out Form 1099-K. Even if you don’t meet that threshold, you will still be expected to declare and pay Uncle Sam’s dues.  

Keeping track of your cryptocurrency transactions and reporting them accurately may be a challenge, especially if you have accounts with multiple exchanges. Hiring a tax accountant for cryptocurrency will help you stay on top of your tax obligations and steer clear of any possible penalties.

Remember the Taxman 

Cryptocurrencies can be an excellent investment. The stories you’ve heard of people making thousands of dollars on Bitcoin are not exaggerated. As you plot your way to crypto riches, don’t forget to tie up any loose ends regarding your tax liabilities. Acquire all the information on what the IRS requires and comply fully. If it gets overwhelming, don’t hesitate to seek the assistance of experienced financial professionals.