What You Need to Know About Taxes Before You Claim Your Next Airdrop

While crypto airdrops are often considered to be “easy money,” they also come with responsibilities.

In recent months, projects like Ethereum Naming Service (ENS) and LooksRare delivered airdrops of ENS and LOOKS tokens, respectively, to their users. Both of these token networks are now worth hundreds of millions of dollars in market capitalization. These airdrops have been successful in turning users into fervent stakeholders. As more projects continue to push towards decentralization, we expect more airdrops in 2022 and beyond.

This post is part of Tax Week. Miles Brooks, CPA, is director of tax strategy at CoinLedger.

Investors receiving airdrops should be aware of the tax implications of their newly earned tokens to avoid unwelcome surprises from the IRS.

Most of the time, airdrop taxation is simple. When you receive an airdrop, you recognize income equal to the fair market value of the tokens received at the time you receive them.

The IRS has defined and used the term airdrop in official tax guidance (in Revenue Ruling 2019-24). However, the word “airdrop” was used only in relation to airdrops following a cryptocurrency hard fork. The agency hasn’t provided official word as to how all airdrops are to be taxed. Most tax experts agree that when you receive an airdrop, the IRS will consider this income to pick up on your tax return.

To determine the fair market value of your airdrop rewards, look at what price the tokens are trading at when you receive them. Sometimes, there isn’t immediate pricing data available for early token projects. If this is the case, calculate the fair market value when a market does become readily available.

In some cases, it can be tricky to pinpoint when you “receive” tokens. Generally, this happens when you have control over the asset – or in other words, when you are free to move or trade your tokens.

If your tokens are priced based on the value of another cryptocurrency such as ether, you’ll need to convert the price to U.S. dollar terms in order to report it on your tax return. Typically, airdrop income is to be reported as “Other Income” on Schedule 1.

If you decide to sell your airdrop rewards, you will incur a capital gain or loss at the time of sale. It’s important to note that you aren’t paying taxes on the same income twice. Rather, you’re incurring ordinary income when you first receive the airdrop and capital gain income once you sell depending on how the price of your tokens has changed since the airdrop.

For example, imagine that you are airdropped $1,000 of UNI from the Uniswap protocol. The value of your tokens then increases to $1,500 and you decide to sell. In this case, you would recognize $1,000 of ordinary income from the airdrop and $500 of capital gain from disposing of the tokens.

If you decide to dispose of airdrop rewards in the future, you’ll need to know the cost basis for your tokens. For airdrop income, this is the value of your tokens at the time you received them, plus any relevant fees.

In the prior example, by picking up $1,000 of airdrop income, this $1,000 becomes your cost basis for those tokens going forward. You can increase your basis by including any gas fees spent to claim the airdrop.

Your tax liability is based on the fair market value of the airdrop at the time you receive it. If the value of your tokens declines significantly, you may be responsible for paying a large tax bill you may not be able to afford.

To avoid this scenario, it’s recommended that you put aside a portion of your rewards when you receive your airdrop to cover the associated tax bill.

Many investors convert a portion of their airdrop income to stablecoins when they receive it, then find protocols that offer interest rewards. This way, investors can stay prepared for tax season while earning passive income.

A difficult part about the taxation of airdrops is that their execution has changed over time and will continue to change. Some airdrops have to be claimed, and may only be available under certain circumstances, while others are automatically distributed to owners of a specific coin. The IRS has not yet released guidance on each one of these specific situations.

Potential taxpayer issues arise with unsolicited airdrops. The airdrop may show up on the blockchain, but in certain circumstances true “receipt” may not actually occur. For example, should you be required to report income from an airdrop if you don’t even know it was received?

Because of how nuanced airdrops can be, and because they are likely to continue to evolve as a tool going forward, it will be very difficult for the IRS to issue timely and well-reasoned guidance on airdrops.

You should speak to a tax advisor if you have questions about how your airdrop should be taxed. Everyone’s circumstances are different, and you will benefit from taking an approach that makes the most sense for you.

Even without explicit IRS guidance, there is a general consensus among tax experts that the IRS will treat airdrops as income when received.

It’s clear the current framework of taxing airdrops upon receipt comes with its problems. Could there be a simple alternative, tax airdrops not on receipt but only upon disposal?

It’s unlikely that the IRS will willingly accept such a deferral of income, and so for now, taxpayers who receive airdrops will have income upon receipt and will be forced to navigate through the uncertainty that comes with the taxation of an emerging asset.

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