Omnia Markets – Education

DeFi projects use dApps or decentralized applications that anyone can develop and use. These applications use utility or native tokens or DeFi tokens that facilitate transactions. These DeFi tokens serve many purposes other than just making payments or being a store of value. 

Cryptocurrencies are pieces of software that transfer value between users. The word ‘crypto’ comes from the Greek word ‘kryptos’ which means hidden. Like cash, they can be used to buy and sell goods and services. But unlike cash, they are not authenticated by a central authority such as the government or a central bank. They exist on the decentralized peer to peer networks of blockchains and are used for several purposes, such as incentivizing miners, storing value, and enabling other transactions on a blockchain. Since there is no single authority that issues cryptocurrencies, the supply and demand of cryptocurrencies are determined by the users collectively. Simply put, a cryptocurrency is a number that is tracked on a blockchain.

Since cryptocurrencies can be used to transfer value, exchanged with other cryptocurrencies, purchase goods and services, converted to fiat or regular currencies, etc., they are considered “property.” Therefore, the regular tax rules that apply to dispositions of property usually apply to cryptocurrencies.

The IRS has released guidance that provides general tax treatment to the use of cryptocurrency as transfer of value transactions (https://www.irs.gov/irb/2014-16_IRB#NOT-2014-2; https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions). The normal rules applicable to the disposition of property, including the rules regarding the capital gain or loss treatment, would apply to cryptocurrency exchanges.

So, would the exchange of one cryptocurrency, say Bitcoin, for another, such as Ether, would qualify for tax deferral provided for like-kind exchanges? The short answer, no. The 2017 tax law made it clear that each cryptocurrency as a distinct property from each other so the like-kind exchange rules for tax deferral do not apply here.

That raises a question the tax treatment prior to 2018, before the law was passed. The IRS’ Office of Chief Counsel issued a memorandum (https://www.irs.gov/pub/irs-wd/202124008.pdf) that clarified that the like-kind exchange treatment did not apply in the case of three cryptocurrencies, Bitcoin, Ether, and Litecoin, if they were exchanged among each other even before 2018. It is unclear whether the same would apply to other cryptocurrencies.

What happens when one simply purchases a cryptocurrency with a regular currency like the U.S. dollar? Is this a reportable transaction on one’s tax return? A mere purchase with a regular currency is not reportable transaction. The purchaser does have to start maintaining records that establish the cost or basis in the cryptocurrency so at later disposition any resulting gain or loss can be calculated and supported adequately.

The IRS in Revenue Ruling 2019-24, (https://www.irs.gov/pub/irs-drop/rr-19-24.pdf) the IRS considered two situations in the event of a “hard-fork” where units of new cryptocurrency are not received in the first case, and another where units of the new cryptocurrency are issued to the holders of the original cryptocurrency. A hard-fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change that results in a permanent fork from the old or legacy distributed ledger and the future transactions are recorded in a new distributed ledger. The IRS clarified that if units of a new cryptocurrency are not issued, then there is no taxable event, but there is when units of a new cryptocurrency are issued to the holders of the “legacy” cryptocurrency.

In Notice 2014-21 ( https://www.irs.gov/irb/2014-16_IRB#NOT-2014-21) the IRS has addressed several transactions involving cryptocurrencies providing guidance in the form of frequently asked questions that every reader should be familiar with.