A “hard fork” is based on the idea of “a fork in the road” where a traveler has to consciously choose to follow one way over the other way. Similarly, a crypto “hard fork” is a major software programming change that requires users to follow a new way over the old way.
Cryptocurrencies are basically software programs that are coded to solve different problems or provide various financial benefits. After software has been deployed for a while, it’s very common for the developers to issue updates or upgrades to the programming. When a cryptocurrency program or “protocol” gets a significant upgrade or coding modification, that’s what basically happens during a crypto “hard fork.”
What is a hard fork?
A hard fork occurs when a cryptocurrency undergoes a software upgrade or protocol change that permanently and significantly modifies it from the legacy distributed ledger. Sometimes a hard fork requires the creation of a new crypto on a new blockchain network, in addition to the first generation crypto that still runs on the old, alternative distributed ledger.
Programmers can decide to roll out a hard fork for a variety of reasons including: to correct security risks found in older versions of the software, to add new functionality, to improve transaction speed or volume per second, to reverse transactions, and more.
If your cryptocurrency went through a hard fork but there was not a new cryptocurrency issued to you, whether through an airdrop or through some other kind of distribution, you do not have taxable income. Basically, if a hard fork does not “fork” over a new crypto to you, it’s not a taxable event.
When is a hard fork taxable and when is it not taxable?
However, if a hard fork upgrade occurs and the developers issue you new cryptocurrency, that is a taxable transaction, and you will have ordinary income equal to the fair market value of the new cryptocurrency when it is received. The receipt of the new crypto is captured on the distributed ledger, also known as the blockchain, so that you can transfer, sell, exchange, or otherwise dispose of the newly created digital asset — hence a taxable event in this case.
How does a hard fork work?
Adding a new rule or process to the programming code creates a new path or fork for transactions to take on the blockchain: one path tracks along the new, upgraded blockchain, and the other path follows the old programming trail. Generally speaking, those individuals who initially stay on the old chain come around to reality and see the benefit and value of the upgraded version of the blockchain — compared to their down-level version. As such, they quickly “level up” and adopt the improved hard-fork coding over the outdated mode.
What’s the difference between a hard fork and soft fork?
While exploring hard forks, we’d be remiss if we didn’t address a similar crypto coding event called a “soft fork.” Hard forks and soft forks are essentially the same in that they both represent a significant software modification on their original blockchain programming.
However, with a soft fork, only one blockchain version is active and viable — namely the newly revised pathway — as users adopt the update. With a hard fork, both the old and new blockchains exist simultaneously. Both types of forks create a software split from an old programming path, but a hard fork creates two separate blockchains and a soft fork produces one.
Regardless of whether it’s a hard or soft fork, you only need to consider potential tax implications if the split produces — and gives you — a new batch of cryptocurrency assets.
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