What is a hard fork? Soft forks, chain splits and what happens to your coins

Blockchains don’t have a company that can push out a software update. When the rules need to change, thousands of independent computers have to agree to run the new version. The name for that change is a fork, and when not everyone agrees, a single blockchain can become two.

This guide explains the two types of fork, why chains sometimes split, what happened with Ethereum and Ethereum Classic, and what a fork means for your coins and your taxes.

What a fork is

NIST, the US standards agency, describes forks as changes to a blockchain network’s protocol and data structures, and divides them into two categories:

• Soft fork: the change is backwards compatible. Nodes that haven’t updated can still transact with nodes that have.
• Hard fork: the change is not backwards compatible. Nodes that haven’t updated reject the blocks that follow the change, which can split the network into multiple versions of the same blockchain.

ethereum.org puts it in everyday terms: forks are when major technical upgrades or changes need to be made to the network. In centrally run software, the company just ships a new version. On a blockchain, every client must update its software to follow the new rules.

One source of confusion: the word “fork” is also used for temporary conflicts, when two blocks with the same number appear at once. NIST notes that those are short-lived and don’t come from a software change. This guide is about rule changes.

Soft forks: tightening the rules

A soft fork makes the rules stricter in a way that old software still accepts. NIST gives a real example from bitcoin: in 2014, a proposal repurposed an operation code that did nothing (OP_NOP2) into CHECKLOCKTIMEVERIFY, which lets a transaction output become spendable only at a point in the future. Updated nodes run the new check; old nodes still see the transaction as valid.

NIST also gives a hypothetical: if a blockchain cut its maximum block size from 1.0 MB to 0.5 MB, old nodes would still accept the smaller blocks, because they’re within the old limit.

The catch is that a soft fork needs enough support. NIST notes that if no or very few nodes upgrade, the new rules simply won’t be followed.

Hard forks: changing the rules

A hard fork changes the rules in a way old software can’t accept. According to NIST:

• At a set point, usually a specific block number, block producers have to switch to the new protocol.
• Every node has to upgrade, or it will reject the newly formatted blocks.
• If some block producers don’t upgrade, they keep producing blocks in the old format, and two versions of the blockchain exist at the same time.
• Users on different versions can’t interact with each other.

Most hard forks are intentional, but NIST warns that software errors can also cause unintentional ones. It describes a 2013 case in which a new version of the most popular bitcoin client introduced a flaw and started two competing chains; the developers reverted to the old version.

Planned upgrades vs chain splits

A hard fork doesn’t have to split anything. ethereum.org explains that forks are usually agreed ahead of time, so clients adopt the changes together and the upgraded chain becomes the main chain. Ethereum’s own history is a list of these planned forks, including The Merge on 15 September 2022, when Ethereum switched off proof-of-work mining and switched on proof of stake. See what is Ethereum?

A split happens when a meaningful part of the community refuses the change and keeps running the old rules. Each side then has its own chain and its own coin.

The best-known split: Ethereum and Ethereum Classic

In 2016, a smart contract called The DAO was attacked. NIST says flaws in the contract let an attacker extract ether worth $50 million. ethereum.org says the contract was drained of over 3.6 million ETH.

ethereum.org describes what followed:

• The community voted on a fix. Any ETH holder could vote through a transaction, and the decision to fork reached over 85% of the votes.
• The DAO fork took effect on 20 July 2016, at block 1,920,000. It moved the funds from the faulty contract to a new one that let anyone who lost funds withdraw 1 ETH for every 100 DAO tokens.
• Some miners refused, because the incident wasn’t a defect in the protocol itself. They carried on with the old chain, which became Ethereum Classic.

NIST notes that the clear majority of support moved to the new fork, while the old one was renamed Ethereum Classic and continued operating. For more on DAOs, see what is a DAO?

What happens to your coins in a split

NIST explains that if a hard fork splits a blockchain, holders end up with independent coins on both chains, so in total they have twice the number of coins. HMRC describes the same thing: holders usually have an equal number of tokens on both ledgers, because the two chains share their history up to the fork.

That doesn’t mean your wealth doubles. The two coins trade separately, and if almost everyone moves to one chain, NIST notes, the other may eventually fall out of use.

In practice:

• On an exchange: the exchange decides whether to support the new coin. HMRC notes that you can only dispose of the new tokens if your exchange recognizes them.
• In your own wallet: you control the keys on both chains, but accessing the new coin may need wallet support. Never type your seed phrase into a site that promises to “claim” forked coins. See seed phrase security.
• Sending after a split: be careful which chain you’re on. Check that your wallet and the recipient support the same network. See how to send crypto safely.

Why hard forks happen

• Upgrades: new features, lower fees or a new consensus mechanism, as with The Merge.
• Fixing a crisis: NIST notes that blockchains can use hard forks to counter malicious users, and that whether losses are reversed is up to the developers and users. The DAO fork is the example.
• Security: if a serious flaw were found in a blockchain’s cryptography, NIST says the only solution might be a hard fork. Hypothetically, if SHA-256, the hash function bitcoin uses, were found to have a flaw, a hard fork would be needed to move to a new algorithm, which could make existing mining hardware useless. NIST also mentions practical quantum computers as a possible future reason.
• Disagreement: when part of the community wants different rules, a contested fork can create a new coin.

How forks are taxed

United States

The IRS answers this directly in its FAQ and in Revenue Ruling 2019-24:

• Soft fork: no income. A soft fork doesn’t create a new digital asset, so you’re in the same position as before.
• Hard fork, no new coins received: no taxable income.
• Hard fork, new coins received: ordinary income in the year you receive them, equal to their fair market value when received. You receive them when you have dominion and control, meaning you can transfer, sell, exchange or otherwise dispose of them, which is generally when the fork is recorded on the ledger.
• Exchange doesn’t support the new coin: Revenue Ruling 2019-24 says you don’t have dominion and control if your exchange doesn’t credit the new coin to your account. If you later become able to dispose of it, you’re treated as receiving it at that time.
• Basis: your basis in the new coins equals the amount you included in income.

When you later sell the new coins, you have a capital gain or loss measured from that basis. See US crypto tax.

United Kingdom

HMRC takes a different approach. Because the new tokens’ value comes from the tokens you already held, it applies section 43 of the Taxation of Chargeable Gains Act 1992:

• The new tokens go into their own section 104 pool.
• The allowable costs of your original pool are split between the two pools on a just and reasonable basis. HMRC doesn’t prescribe a method, but it can challenge one it thinks isn’t reasonable.
• If your exchange doesn’t recognize the new tokens, you may be able to put all the costs against the original tokens, or split the costs and consider a negligible value claim for the new ones.

So in the UK the fork itself isn’t treated as income; tax comes when you dispose of either token. See UK crypto tax.

Canada

We haven’t found CRA guidance specific to forks that we could check for this article. If you received coins from a chain split, keep records of what you received and when, and ask a tax professional or check the CRA’s cryptocurrency guidance.

Key takeaways

• A soft fork tightens the rules and old software still works; a hard fork changes them and old software is left behind.
• Most hard forks are planned upgrades that don’t create a new coin.
• A chain split gives you coins on both chains, but your exchange decides whether you can use the new one.
• In the US, new coins from a fork are income; in the UK, they share your original cost.

For related guides, see crypto airdrops explained, what is a 51% attack? and bitcoin vs Ethereum.