Arizona residents can soon benefit from state-level tax treatment of crypto airdrops that differs from federal guidance
In July 2022, Arizona Governor Doug Ducey signed into law H.B. 2204, which specifically excludes the value of airdrops from Arizona state taxable income. It also allows the deduction of gas fees.
For the uninitiated, an airdrop is the free, unsolicited provision of digital assets to a community of crypto investors by the developers of those assets in order to promote them. And gas fees are simply the network transaction fees investors pay for transacting on certain blockchains, most notably the Ethereum blockchain, in order to compensate the blockchain’s miners or validators.
Arizona is the first state to clarify in its tax code that airdrops are non-taxable events. This treatment is the opposite of current federal law—the IRS considers airdrops taxable events.
Yes and no.
Arizona’s new law creates different treatments for Arizona state income taxes and federal income taxes. Starting in 2023, the value of an airdrop, if there is one, is free of state taxes for Arizona residents. On the federal side, that value is taxed as ordinary income to the recipient.
Up to this point, the different treatment is pretty easy to grasp. Arizona residents receiving airdrops in 2023 will need to report the value of those airdrops on their federal taxes but not on their Arizona state taxes.
But here’s where it gets interesting.
Contrary to what would seem like a normal disparity between state and federal tax treatment, the legislative text of the Arizona law creates an interesting result in state taxes when it comes to selling the airdropped tokens. Specifically, the airdropped units appear to maintain the same acquisition cost basis for both federal-tax purposes and Arizona-tax purposes.
Acquisition cost basis (or simply, “basis”) is tax jargon that just means the amount of money spent to buy something. Generally, if an individual buys property, such as a car or stock or any other personal or investment property, and later sells that property, he or she only has to pay tax on whatever gain there is – measured by the difference between the proceeds received from the sale and then subtracting the cost basis. The first thing to ask then is, what did the person buy the property for, or, what is that property’s cost basis? The gain is therefore, quite simply, the amount received from the property’s sale minus whatever the person originally paid for it.
For federal tax purposes, an airdrop recipient’s basis in the received digital assets is going to be the amount treated as income from its receipt. This is measured as the fair market value of the airdropped assets at the moment in which the recipient has dominion and control over them, which is basically more tax jargon for the ability to do whatever he or she wants to do with them. That’s because the IRS considers the receipt of airdropped digital assets to be income to the recipients.
The IRS further explains how this works In Revenue Ruling 2019-24, which addresses airdrops in the context of hard forks (i.e., when a protocol change results in the creation of two separate, parallel cryptocurrencies). That guidance states that newly-created airdropped assets received by holders of the original blockchain’s assets are income to those individuals. When an individual receives income in property (like a digital asset) rather than in cash, his or her basis is considered to be its fair market value upon receipt, as if he or she had received taxable cash and then immediately bought the property with that cash.
Federal law avoids double taxation on the value of the airdrop, which is a good tax policy. In other words, the value of the airdrop is taxed at receipt of the airdrop but not in a later sale; only a gain, if any, is taxed at a later sale. However, the Arizona law, partly because of how it interacts with federal tax law, results in the complete tax-free treatment of airdrops at the state level.
What the new Arizona law essentially says is the opposite of the IRS’ treatment of airdropped digital assets: their recipients have no taxable income resulting from the airdrop.
As noted above, this is not a big deal. But in most situations like this, when the value of property is not included in income upon receipt, the value of that property is also not credited into the cost basis because doing so is generally viewed as a tax windfall. Yet, the new Arizona law appears to achieve precisely this result.
Now, if you’re a tax professional, you’re probably thinking the new Arizona law should create a disparity in cost bases for the holder (or hodler, as you were) of such assets, a federal cost basis equal to the fair market value of the assets upon receipt and a state cost basis of zero—essentially a state-side deferral-until-sale of the tax owed on the airdropped value of the assets.
But as described above, the new Arizona law appears to be simpler than that, because Arizona’s state tax code requires its residents to adopt their federal adjusted gross income for Arizona gross income purposes, cost bases and all. See Ariz. Rev. Stat. § 43-1001(2). Then Arizona residents make upward or downward adjustments as necessary. See Ariz. Rev. Stat. § 43-1021 (Addition to Arizona gross income) and § 43-1022 (Subtractions from Arizona gross income). H.B. 2204 adds nothing about airdrops to Arizona gross income.
So what could have been a complicated mess, exposing individual taxpayers to the headache of tracking two different cost bases for the same assets, is actually only complicated one time over. Meanwhile, the state of Arizona collects nothing on the value of airdropped tokens, neither at the point of airdrop and not deferred until sale. All that Arizona receives is a tax on any gain in the assets’ value after the airdrop.
If you’re fortunate enough to receive airdrops while residing in Arizona, congratulations. Your taxes are probably going to be complicated, just not as complicated as they could have been.
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