As assets such as Bitcoin and Ethereum become household names, many veteran participants in the digital asset industry are moving on to the comparatively greater volatility and potential gains offered by alternative digital assets (Altcoins), non-fungible tokens (NFTs), and other projects.

Whether by way of investment activity, trade, or even performance of services, these taxpayers may receive various combinations of highly liquid mainstream digital assets that are widely traded across many different centralized exchanges (CEXs). However, they may also receive Altcoins and NFTs, which may only trade via decentralized exchanges (DEXs). Taxpayers dealing in digital assets should be aware of the unique risks and opportunities that come with transacting in digital assets with varying degrees of liquidity and/or different mechanisms of exchange.

Gain on Disposal of Digital Assets Generally

For U.S. federal income tax purposes, most digital assets remain classified simply as property under IRS Notice 2014-21. Under this guidance, as well as the supplemental FAQs and IRS Publication 544, a taxpayer realizes gain or loss on the exchange of digital assets under the principles of Internal Revenue Code Sec. 1001. Under these principles, the fair market value of property received, in excess of the taxpayer’s basis in the property disposed of, represents taxable gain. Treasury Regulation 1.1001-7, dealing specifically with digital assets, provides that fees paid in digital assets to effect a disposal, for example,  commissions paid to a broker, or gas fees (i.e. tokens paid to the operators of a blockchain network such as miners or validators to compensate them for processing transactions and securing the blockchain network), represent the disposal of those assets in exchange for services (on which gain or loss would also theoretically be realized). Valuing digital assets with high trading volumes across multiple different exchanges can be relatively straightforward, especially where the assets are readily exchangeable on U.S.-based centralized exchanges. However, establishing the fair market value in U.S. dollars (USD) of less liquid assets may be more challenging.

Valuing Less Liquid Coins

In valuing Altcoins that trade only on a DEX, the current price of a trading pair with a USD stablecoin (if available) is an important reference point and can often be a reliable indication of USD fair market value. However, even if the token has a USD stablecoin trading price listed and available, it is important to consider its trading volume and volatility. In the FAQs to Notice 2014-21, IRS has indicated that where digital assets are traded by way of a cryptocurrency exchange, the fair market value of disposed assets should, when possible, make reference to the USD value of the assets received on the exchange. (See IRS, FAQs on Virtual Currency Transactions, Q26). Where digital assets are exchanged by way of a peer-to-peer exchange, the taxpayer may use a reasonable method to reflect the accurate representation of the asset’s value. IRS will specifically accept, but does not require, an analysis conducted by a blockchain explorer analyzing worldwide multi-exchange indices. (See IRS, FAQs on Virtual Currency Transactions, Q27). In the case of Altcoins traded on a DEX, the functions of volume and volatility are reflected in more concrete financial terms in the concepts of slippage or price impact. Most DEX user interfaces will display the exchange rate for the token, as well as an estimate of the slippage or price impact, which should be considered along with the exchange rate.    

If a large block of tokens is being valued, there might not be a market for the immediate sale of the block at all, and an adjustment to value may be required to reflect the lack of liquidity. This involves an analysis of the token’s volatility and judgment regarding the time it would take to liquidate the block in question. A number of empirical studies and analytical models can be used to determine appropriate adjustments.

Additionally, the traded price of thinly traded tokens may not necessarily be indicative of fair market value. If liquidity is too low to place any reliance on the traded price, the value can potentially be derived by considering traded tokens that are comparable to the subject token. In this case, one needs to consider and adjust for differences between the identified comparable tokens and the subject token regarding the stage of development, potential economic opportunity, and risks, among other factors.

Whether valuing a large block of tokens or tokens with very low trading volume, opportunity costs can provide an observable proxy for value. Certain tokens function as a medium of exchange for specific products and services. In such cases, one can assess the market price for these products and services and consider those as a proxy for the valuation of the tokens exchanged under the reasoning that a rational user would not use the utility token if the same goods or services were available elsewhere at a lower cost.  Similarly, if the tokens are being used as consideration in a transaction, one can assess the value of what is received in exchange for the tokens as an indication of value for the tokens themselves. (See also IRS, FAQs on Virtual Currency Transactions, Q15 and Q17).

The Takeaway

Taxpayers may need to take additional steps when recording certain transactions in less liquid digital assets to comply with IRS’s requirement of a reasonable and accurate reflection of the fair market value of the digital assets disposed of or received. Under some circumstances, an analysis of proxies for the fair market value may be beneficial.

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