Bitcoin has been around for almost 10 years. But the tax rules associated with “virtual currency” are constantly evolving. In 2018, tax matters will become even more complicated for because relevant provisions of the Tax Cuts and Jobs Act take effect starting in 2018.
This is what you should know about the brave (relatively) new world of virtual currency.
Bitcoin is currently the most widely recognized form of virtual currency, emerging in 2009. It, and other virtual currencies, may also be referred to as ‘digital,’ ‘electronic,’ or ‘cryptocurrency.’
Unlike cash or credit cards, it’s unlikely local Maine businesses are going to accept Bitcoin payments for routine transactions. But a growing number of larger companies—including Overstock.com, the Sacramento Kings, and online gaming company Zynga—now accept Bitcoin payments. It’s likely this trend will continue.
Bitcoin has an equivalent value in real currency. Users can digitally trade it. Bitcoin can also be purchased with real currencies (ie, U.S. dollars or euros) and exchanged for real currency. To obtain Bitcoin, you can use a virtual currency ATM or an online exchange that usually charges a nominal transaction fee.
Once you have some Bitcoin, you can purchase goods or services using “Bitcoin wallet” software installed on your computer or mobile device. When you buy something, the software digitally posts the transactions to the global public ledger (the blockchain). This ensures that the same unit of virtual currency can’t be used multiple times.
Avoiding the transaction fees charged by credit card companies and online payment providers (such as PayPal) is one reason some merchants accept Bitcoin. And it’s also popular in countries such as Argentina and Iran, where national currencies are susceptible to inflation, corruption, capital controls, or international sanctions.
There are only 21 million units of Bitcoin, so some people obtain them for investment purposes, hoping that the value will appreciate over time. Some of those units haven’t been issued yet and are reserved for Bitcoin “miners.” These people provide computing power to verify and record virtual currency payments into the blockchain (the global public ledger).
The Financial Industry Regulatory Authority (FINRA) warns that Bitcoin is highly speculative and investors should not risk more in Bitcoin than they’re willing to lose.
Federal Tax Reporting
Virtual currency has raised many tax-related questions. Unfortunately, there has been limited guidance from the IRS as they catch up with the new technology.
In a 2014 ruling, the IRS established that Bitcoin and other convertible virtual currency should be treated as property, not currency, for federal income tax purposes.
This means businesses that accept Bitcoin payments for goods and services must report gross income based on the fair market value of the virtual currency when the payment was received. The fair market value is measured in equivalent U.S. dollars.
From the perspective of the buyer, purchases made using Bitcoin result in a taxable gain if the fair market value of the property received exceeds the buyer’s adjusted basis in the Bitcoin exchanged. Conversely, a tax loss is incurred if the fair market value of the property received is less than its adjusted tax basis. The character of a gain or loss from the sale or exchange of Bitcoin depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
For example, suppose you buy a $2,000 rug on Overstock.com using Bitcoin. You originally acquired the Bitcoin that you used for the rug for $1,200 in 2016 using a Bitcoin ATM. Unless you’re a professional Bitcoin miner or broker, you must report an $800 capital gain ($2,000 – $1,200) on your personal tax return.
The transaction would be more complicated if your Bitcoin had been acquired at different dates and prices. Generally, taxpayers will prefer to exchange their highest-value Bitcoin first to minimize the taxable gain or generate a beneficial tax loss. If the Bitcoin has been held for less than a year, the gain may be taxed at higher ordinary income tax rates, unless you’re a professional Bitcoin miner or broker.
On the other hand, wages paid to employees using virtual currency are taxable to the employees. Employers must report such wages on W-2 forms. The wages are still subject to federal income tax withholding and payroll taxes, based on the fair market value of the virtual currency on the date of receipt.
Also taxable are payments using virtual currency made to independent contractors, qualifying Bitcoin miners and other service providers. The rules for self-employment tax generally apply, based on the fair market value of the virtual currency on the date of receipt. Normally, payers must issue 1099-MISC forms.
Any payment made using virtual currency is subject to information reporting to the same degree as any other payment made in property.
Tax Treatment of Bitcoin Exchanges
One gray area related to virtual currency is how to treat the capital gains and losses realized by taxpayers who invest in Bitcoin and exchange it for real currency (such as U.S. dollars). Before, some tax experts claimed that these exchanges qualified as “like-kind exchanges” of properties under Section 1031 of the tax code. With a like-kind exchange, no current tax is due on the exchange of investment or commercial properties. To qualify for the favorable tax treatment, the properties you relinquish and receive must be similar in nature.
This was an easy solution for Bitcoin traders. They could use the rules for like-kind exchanges to avoid current tax bills.
However, the Tax Cuts and Jobs Act gets rid of tax-deferred like-kind exchanges — except for real estate exchanges — for 2018 and beyond. However, prior-law rules that allow like-kind exchanges of property other than real estate still apply if one half of an exchange was completed as of December 31, 2017, and one half remained open on that date.
This change creates a problem for Bitcoin investors who trade currencies: They must use the Bitcoin price when it was acquired and the price on the date of the exchange to compute the resulting capital gain or loss. Unlike securities sales, no authority is tracking these figures for investors. In addition, it’s not clear whether transaction costs and accounting fees related to virtual currency can be deducted by investors.
Most taxpayers are unaware of the requirements for reporting virtual currency transactions. For the 2013 through 2015 tax years, the IRS estimates that fewer than 900 taxpayers declared Bitcoin earnings each year.
The IRS plans to increase compliance in this area. Underpayments of tax due to Bitcoin transactions could be subject to penalties unless the taxpayer can establish that the failure to file correctly was due to reasonable cause.
The IRS has identified virtual currency transactions as a possible source of additional tax revenue. But it has issued very limited guidance on the reporting requirements. For the latest developments on reporting Bitcoin and other virtual currency exchanges, contact your tax advisor.