Yes, “Bitcoin” is booming, but most people don’t understand what it really is. Basically, Bitcoin is a type of “virtual currency” and is one of the most popular of its kind. While it is still gaining acceptance among the general population, virtual currency like bitcoin can be used to buy goods from many different vendors, retailers, and shops. In fact, you can use bitcoin to make purchases on Amazon (see, http://bitcoinist.com/2-3-billion-people-use-bitcoin-amazon/).
So, because of its intended use, one would think that bitcoin would be treated as regular “currency” – even Japan has recognized it as a valid currency (http://www.coindesk.com/japan-bitcoin-law-effect-tomorrow/). However, the U.S. government is very wary of it (http://www.newsbtc.com/2016/12/19/us-feels-threatened-by-increasing-popularity-of-bitcoin-and-other-cryptocurrencies/) and is behind the curve in acknowledging its increasing worldwide acceptance. But, of course, where there is money involved, no matter its type, the IRS wants its share.
So, how is virtual currency like bitcoin taxed? Surprising, despite its “currency” brand, the Internal Revenue Service doesn’t treat it as currency, but rather views it as “property” like stock of a corporation. Despite efforts to the contrary (most publications from the IRS are somewhat hard to read, even for tax professionals), the IRS released a well-written piece on the taxation of bitcoin in Notice 2014-21 utilizing a question-and-answer format. This article will condense Notice 2014-21 even further.
Typical Tax Events
There are many taxable events associated with virtual currency. The most popular include:
- Buying and Selling on an exchange or with another person;
- Buying goods or services with virtual currency; and
- “Earning” bitcoin through performance of services on behalf of another (as an independent contractor or employee)
Buying and Selling Bitcoin or Using Bitcoin to Sell and Acquire Other Assets
Because the IRS deems bitcoin as property, it is taxed at capital gains rates for purchase and sale transactions (i.e., selling and acquiring property in exchange for bitcoin). For bitcoin held for longer than one year, the exchange is taxed at long term capital gains rates. These rates are dependent upon your particular income tax bracket and range from 0-20%.
By contrast, gains earned on assets held for one year or less are considered short term capital gains. These are taxed at ordinary income tax rates. These can be as high as 39.6%. Since the long-term rates are more favorable than the ordinary income tax rates, keeping your virtual currency for longer than one year prior to its disposition can be more tax efficient.
However, because bitcoin is taxed like stock of a corporation, a person must know their tax basis of the amount of bitcoin utilized in a transaction. An asset’s tax basis is generally the cost the taxpayer incurred to acquire the asset. So, for Bitcoin, the tax basis of the “block” of bitcoin you acquired today is the amount you paid for it today. And, like stock, you need to keep track of your tax basis of your bitcoin “block” (WRITE IT DOWN) so you can determine the amount of taxable gain or loss you’ll have when you dispose of it later.
To determine the tax consequences of a transaction using bitcoin or any other virtual currency, here are the figures you need to know and keep recorded:
- Original Purchase Price of Bitcoin when you first bought it (OPP)
- Fair Market Value – What the vendor charges you when you trade for an asset (FMV)
- Amount of Bitcoin spent on the transaction – Found by taking FMV divided by Current Bitcoin Value (BTC)
- Cost Basis – Found by taking how many bitcoins spent times the original price (CB)
With these crucial pieces of information, you can find your Capital Gain or Loss. For example, here’s what it looks like:
OPP of Bitcoin block acquired: $300.00
FMV of the asset to be acquired: $100.00
Current Bitcoin Value of block at time of asset acquisition: $500.00
Amount of BTC spent at time of transaction: 0.2 BTC (100/500)
Taxable Capital Gain: $60.00 (0.2 X 300)
The Taxable Gain of $60 is what you would report on your tax return and the type is gain (long-term or short-term capital gain) will depend on the length of time you held onto that block. (Please note that fees associated with the above transaction are not included.)
As mentioned earlier, companies are starting to use bitcoin as an alternative to cash when they compensate employees or independent contractors for work performed on behalf of the company. But again, bitcoin is not cash or currency in the eyes of the IRS. Rather, this compensation method is more akin to a stock grant to the service provider, although, different from a true stock grant, no ownership or other rights in the company attach to payments by bitcoin. So, the employee / contractor needs to keep track of their “basis” in the bitcoin received, and the company needs to issue a IRS form 1099 or a W-2 to the recipients to show the compensation paid out. And, the company is still subject to self-employment taxes (if otherwise required) and withholding and payroll taxes.
In Conclusion . . .
The emergence of bitcoin and other virtual currencies has created a whole new world for investors and entrepreneurs in doing business, but a lot of questions remain at all levels of U.S. government regulation of these types of currencies. For example, would a trade of a particular amount of bitcoin for an equal value of etherium qualify for non-taxable “section 1031 like-kind exchange” treatment under the Internal Revenue Code? That, and many other questions have not yet been answered. (https://klasing-associates.com/possible-1031-exchange-bitcoin-ethereum-electroniccrypto-currencies/)
That doesn’t mean that virtual currencies shouldn’t be discounted. Like the automobile, new inventions take a while to be accepted by the general population with government involvement soon to follow, but I believe virtual currencies will compliment and may actually replace current money in the future and we all need to be aware of the consequences in working with them.