We’ve compiled a dictionary of digital asset and tax-related terminology to help you better understand some of the words and phrases you’ll see on this site.
AirDrop
Airdrops often come into existence through a hard fork. For example, in 2017 Bitcoin underwent a hard fork and Bitcoin Cash was created and airdropped to existing Bitcoin owners. Airdrops can also occur through promotional incentives, such as watching an educational video.ad, and reach out to schedule time with our team.
Blockchain Fork
In the simplest terms, a fork refers to a software update to a blockchain network or when two incompatible blocks are mined, splitting one chain into two. This can happen for a few reasons.
First, a fork can take place on accident when two miners mine blocks almost simultaneously. Blockchain protocols are able to resolve this by abandoning the shorter chain when one side grows longer than the other. The abandoned blockchain blocks are referred to as “orphan,” “uncle,” or “ommer” blocks.
A fork can also occur purposely when updates are made to a blockchain’s protocol, potentially diverging into two paths forward. When an update is proposed to the nodes running the blockchain, they can either upgrade and accept the changes or ignore them. If any of the nodes reject the changes, depending on the change to the protocol, either a hard or soft fork will occur.
Cryptocurrency
The Internal Revenue Service (IRS) broadly classifies Cryptocurrency as “a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency.” This broadly defined view by the IRS encompasses all digital currencies.
Most cryptocurrencies are based on blockchain technology. Blockchain technology provides the benefit of being immune from counterfeiting or double-spending. Cryptocurrency that is based on a decentralized blockchain is not bound to a sovereign government and therefore relies on consensus protocols rather than a central authority.
Cryptocurrency Exchanges
Cryptocurrency exchanges provide market liquidity to buy, sell, or trade cryptocurrency. Similar to an equity broker selling stocks, you can buy thousands of different cryptocurrencies through exchanges. When you purchase cryptocurrency on an exchange it will be deposited into a wallet on their platform. Most exchanges allow the ability to transfer assets into offline hardware wallets, or onto other exchanges. It is recommended to trade on exchanges that have the proper licenses and security measures.
Cryptocurrency Gains / Capital Gains (I.R.C. § 1202)
Selling cryptocurrency for more than your cost basis (the price you paid for the asset) will result in a capital gain. Your capital losses will offset capital gains on individual transactions. Capital gains can be either long-term or short-term. A gain will be considered long-term if it was held for more than one year or short-term if under a year. Long-term gains are eligible for favorable tax rates, whereas short-term gains are taxed pursuant to the ordinary income tax rates.
Cryptocurrency Information Reporting
The IRS requires Cryptocurrency exchanges to report certain taxable transactions to a taxpayer and to the IRS on the applicable 1099.. Taxpayers should use the information on the 1099 to complete their taxes. Taxbit specializes in information reporting and is skilled in helping exchanges and users with information reporting.
Cryptocurrency Losses (I.R.C. §§1211 and 1212)
A Cryptocurrency loss occurs when a taxpayer sells Cryptocurrency for less than their cost basis, meaning the price they paid when they purchased the asset. If a taxpayer has a net capital loss for the year then they may claim the capital loss deduction. Taxpayers may claim up to $3,000 a year in capital loss deductions, as well as carry forward excess losses into future years. Taxbit tracks capital loss carryforwards for its users in order to maximize their tax refund.
Cryptocurrency Tax Rate
Cryptocurrency gains are classified as either short or long-term. As of 2020, the long-term (investments held for more than twelve months) capital gains tax rate is as follows:
| Tax Rate | Single | Married Filing Jointly | Head of Household | Married Filing Separately |
|---|---|---|---|---|
| 0% | $0 to $40,000 | $0 to $80,000 | $0 to $53,600 | $0 to $40,000 |
| 15% | $40,000 to $441,450 | $80,000 to $496,600 | $53,600 to $469,050 | $40,000 to $248,300 |
| 20% | $441,450+ | $496,600+ | $469,050+ | $248,300+ |
Short-term (investments held for less than twelve months) capital gains scale with the federal income tax brackets. The 2020 short-term capital gains rates are as follows:
| Tax Rate | Single | Married Filing Jointly | Head of Household | Married Filing Separately |
|---|---|---|---|---|
| 10% | $0 to $9,875 | $0 to $19,750 | $0 to $9,875 | $0 to $14,100 |
| 12% | $9,876 to $40,125 | $19,751 to $80,250 | $9,876 to $40,125 | $14,101 to $53,700 |
| 22% | $40,126 to $85,525 | $80,251 to $171,050 | $40,126 to $85,525 | $53,701 to $85,500 |
| 24% | $85,526 to $163,300 | $171,051 to $326,600 | $85,526 to $163,300 | $85,501 to $163,300 |
| 32% | $163,301 to $207,350 | $326,601 to $414,700 | $163,301 to $207,350 | $163,301 to $207,350 |
| 35% | $207,351 to $518,40 | $414,701 to $622,050 | $207,351 to $311,025 | $207,351 to $518,400 |
| 37% | $518,401+ | $622,051+ | $311,026+ | $518,401+ |
If an asset is in a capital gain position then it can be beneficial to hold the asset for a year in order to realize long-term tax advantaged rates.
FIFO Cryptocurrency Cost Basis Method
First in First Out (FIFO) is one of two supported methods for determining the cost basis of Cryptocurrency.
FIFO calculates capital gains according to the difference between the price of the sale and the earliest buy price. For example:
Tina Taxpayer purchased one Bitcoin in January, one Bitcoin in February, and one Bitcoin in March. She then sells one Bitcoin in October and one Bitcoin in December. Tina’s gain on the October sale will be the difference in the sales price and the January purchase price, as January was the first purchase date. The December sale will be the difference in the sales price and the February purchase price. And so on. First in, first out, got it?
Hard Fork
A hard fork describes when a change is made to a blockchain protocol that is incompatible with the original protocol. In this case, the chain splits and the two chains continue on in parallel, independent of each other. The two chains share their full transaction history and state up until the mined blocks diverge.
An example of this was when Bitcoin Cash forked from the Bitcoin blockchain in 2017. To increase Bitcoin’s transaction throughput, some core developers wanted to increase the maximum block size from 1MB to 8MB. Because most nodes were specifically configured to mine a 1MB size block, they wouldn’t be able to easily accept this fundamental protocol update to mine the 8MB blocks. The block size debate became quite political and ended up with the smaller group of 8MB supporters deciding to implement the upgrade and create a hard fork from Bitcoin into Bitcoin Cash without forcing the whole Bitcoin community to agree.
In the US, the IRS has issued guidance regarding the tax implications of a hard fork in Rev. Rul. 2019-24. This says that if you receive a new coin as the result of a chain-splitting hard fork, the receipt of those coins is income – with the amount of income equal to the value of the coins at the moment of receipt.
How does a hard fork differ from an airdrop? A crypto airdrop is a transfer of free cryptocurrency into users’ wallets. These coins live on an existing blockchain that a user is already transacting on. Although both airdrops and hard forks can result in a user obtaining new cryptocurrency, they are fundamentally very different events.
Initial Coin Offering (ICO)
An ICO is the cryptocurrency equivalent to an initial public offering. However, oftentimes ICO’s come from new companies that have not yet developed a product or received traction. In the U.S. it is typically in violation of SEC regulations to distribute tokens through an ICO to people who are not accredited investors.
IRS Form 1099
IRS Form 1099 is a federal tax form provided to tax filers who receive money from sources other than their employer. Form 1099 comes in a variety of different types depending on the economic substance of the transaction These include:
- 1099-B for brokerage transactions and barter exchanges, such as a Cryptocurrency trade or sale;
- 1099-C for a cancellation of debt over $600;
- 1099-DIV for income received through dividends or stock distributions of $10 or more;
- 1099-INT for interest of $10 or more earned
- 1099-R for retirement income;
- 1099-K for third party network transactions relating to the payment for goods or services;
- 1099-MISC for other income; or
- 1099-NEC for non-employee compensation (independent contractor income).
IRS Form 1099-B
IRS Form 1099-B provides a taxpayer with a record of proceeds and cost basis received from broker and barter exchanges. A taxpayer will then need to transfer this information onto an IRS Form 8949 when doing their federal income taxes.
Form 1099-B is generally the form used by brokerage firms to report stock, commodity, or cryptocurrency gains and losses for the year. This form reflects a taxpayer’s cost basis, making it easy for the taxpayer to determine their overall tax position for the year.
IRS Form 1099-K
IRS Form 1099-K provides a taxpayer with a record of their payment receipts from sellings goods and services. IRS Form 1099-K is intended for sellers of goods or services, such as Ebay or Etsy sellers. Some cryptocurrency exchanges have previously issued Form 1099-K aggregating a user’s trading volume. This approach is incorrect and leads to IRS audits for unreported income. Most exchanges have correctly transitioned to reported trading activity on Form 1099-B.
IRS Form 8949
IRS Form 8949 is filed with an annual federal income tax return and lists a taxpayer’s “sales and other dispositions of capital assets,” including gains derived from Cryptocurrency transactions. The information required for Form 8949 will generally come from a Form 1099-B provided by a taxpayer’s cryptocurrency exchange. Taxbit makes it easy to aggregate information across trading sources and generate the required IRS 8949 tax forms.
LIFO Cryptocurrency Cost Basis Method
Last in First Out (LIFO) is an accounting method that calculates gains on the difference between the price of the sale and the most recent buy price. Taxpayers typically have superior tax results through specific identification and therefore LIFO is rarely recommended.
Margin Trading
Margin trading is leveraging your assets in order to have greater market exposure. Exchanges that allow margin will essentially make you a loan with your cryptocurrency as collateral in order to have the potential for greater returns. Trading cryptocurrency on margin can carry greater risks, but have the potential for greater returns.
Mining
Mining is the process in which proof of work (POW) protocols verify transactions and give miners cryptocurrency in return for their work. Miners do the work of verifying blockchain transactions and prevent double-spending of assets. This process was developed by Bitcoin’s founder, Satoshi Nakamoto.
Proceeds
Proceeds is the price you sold or traded a cryptocurrency for. If you trade frequently then you will have a larger proceeds amount. Notably, you are not taxed based solely on the proceeds you generate. Rather, deducting your proceeds against your cost basis will give you your gain or loss amount.
Soft Fork
A soft fork is an event when an upgrade to a protocol is released, but it’s backward compatible. This means that the two versions of the protocol can coexist together and either version of the software can be used for the nodes of the blockchain network.
A soft fork happened on the Bitcoin blockchain on August 23, 2017, with the Segregated Witness (SegWit) protocol upgrade. SegWit improved the scalability of Bitcoin by allowing for more transactions per block. It does this by changing the transaction format where the “witness” information is removed from the input field of the block, instead storing that information outside the base transaction block.
Specific Identification Cost Basis Method
Under Specific Identification, a Cryptocurrency trader can specify which asset it is selling and determine gains/losses based on the cost basis of that specific asset. Taxbit automates this process by selecting the most tax beneficial assets to dispose of. Specific identification is typically the best tax method for minimizing liability.
Staking
Staking cryptocurrency is the process of holding cryptocurrency to verify transactions and support the network. Staking allows you to generate passive income by holding coins. The proof-of-stake mechanism avoids the need of the special equipment and energy costs associated with mining.
