Federal, State, Local and International Taxes - The use of bitcoin and other virtual currency
has increased in recent years. It is estimated that over 80,000 businesses now
accept bitcoin, including mainstream companies such as Overstock.com, 1-800
Flowers, and Dish Network.
Background. Bitcoin is an online digital
currency that was created in 2009 by an unknown computer programmer using the
alias Satoshi Nakamoto. Bitcoins are created by mining, a process whereby
computers are used to solve complex mathematical problems. Miners who
successfully solve these problems are rewarded with bitcoins. A finite number
of bitcoins will be produced, so the recoverable pool of bitcoins is decreasing
gradually. The number of bitcoins available to be mined is capped at 21 million
and all bitcoins are expected to be mined by 2140. Once created, bitcoins can
be sold, traded on an exchange, or used to buy goods and services. Bitcoin
operates as virtual currency and has no physical form. Instead, bitcoins
transfer from computer to computer using cryptographics. Each bitcoin consists
of a coded Internet address that the owner stores in a digital wallet. Bitcoins
are not backed by any government or bank and no one can be forced to accept
them. Unlike credit cards, bitcoins have no processing fees. They are being
accepted by an increasing number of businesses.
Taxation of virtual currency. IRS provided
guidance on the U.S. tax consequences of transactions in, or transactions that
use, convertible virtual currency (including bitcoin) in Notice 2014-21, 2014-6
IRB 938. This guidance, in Q&A format, applies well-established tax
principles to virtual currency. Notice 2014-21 defines virtual currency as “a
digital representation of value that functions as a medium of exchange, a unit
of account, and/or a store of value.” It says although virtual currency
operates like “real” currency and is customarily accepted as a medium of
exchange, it does not have legal tender status. The Notice is the starting
point for analyzing the tax consequences of bitcoin, but it does not address
all of the issues. IRS recognized this and has requested public comments
regarding other aspects of virtual currency transactions that should be
addressed in future guidance.
Virtual currency is property. Virtual
currency is treated as property for tax purposes, and the general tax
principles that apply to property transactions apply to virtual currency.
Notice 2014-21 says that taxpayers recognize gain or loss on the exchange of
virtual currency for other property. As a result, gain or loss is recognized
every time that bitcoin is used to purchase goods or services.
Treating bitcoin as property creates an
accounting nightmare for taxpayers who use it for everyday purchases because a
taxable transaction occurs every time that a bitcoin is exchanged for goods or
services. There is currently no de minimis exception to this gain or loss
recognition. Taxpayers must track their bitcoin's basis continuously to report
the gain or loss recognized on each transaction properly. It is easy to see how
this treatment can discourage the use of bitcoin for everyday transactions. The
loss recognition on bitcoin transactions is particularly problematic. A
deduction is allowed only for losses incurred in a trade or business or on a
transaction entered into for profit. Whether bitcoin is held for investment or
personal purposes may be difficult to determine, and further guidance is
needed.
Basis and recordkeeping. It is important for
bitcoin owners to properly track basis. Bitcoin's value has been extremely
volatile since its inception. The default rule for tracking basis in securities
is FIFO. Taxpayers can also determine basis in securities by using the last-in,
first out (LIFO), average cost, or specific identification methods. The general
opinion is that these methods should be available for property that does not qualify
as a security, and that taxpayers investing in bitcoin should use the method
that is most beneficial to them. However, no direct authority supports this
position.
It may be difficult to use specific
identification for bitcoin because it has no physical existence and is a
divisible virtual currency. Taxpayers must track their bitcoin lots carefully
to minimize gain. Each bitcoin purchase should be kept in a separate online
wallet and appropriate records should be maintained to document when the wallet
was established. If a taxpayer uses an account with several different wallet
addresses and that account is later combined into a single wallet, it may not
be possible to determine the original basis of bitcoin that is used in a
subsequent transaction.
Character of gain or loss. The character of
gain or loss on bitcoin transactions depends on whether the bitcoin is a
capital asset in the taxpayer's hands. Gain on the sale of bitcoin that
qualifies as a capital asset is netted with other capital gains and losses. A
net long-term capital gain that includes gain on bitcoin transactions is
eligible for the preferential tax rates on long-term capital gains.
Bitcoin gain constitutes unearned income for
purposes of the unearned income Medicare contributions tax introduced as part
of the Affordable Care Act. As a result, taxpayers with modified adjusted gross
income over $200,000 ($250,000 for married taxpayers filing jointly) are
subject to an additional 3.8% tax on bitcoin gain.
Code Sec. 475 says that any security that is
inventory in the hands of a dealer is included in inventory at FMV. Also,
unless specifically identified as held for investment, securities that are not
inventory are marked to market and treated as sold on the last business day of
the year. IRS has not provided guidance on whether bitcoin is a security, and
it is unclear whether the rules of Code Sec. 475 apply to bitcoin dealers.
Whether bitcoin is classified as a security also determines its treatment under
the wash sale and like-kind exchange rules.
Virtual currency is not currency. Virtual
currency is not treated as currency that can generate foreign currency gain or
loss. Treating bitcoin as property rather than currency is favorable to
investors because of the preferential tax rate on long-term capital gain.
Foreign currency gain or loss is treated as ordinary income under Code Sec.
988. Because bitcoin is not currency for foreign currency gain or loss
purposes, individuals are not eligible for the $200 per incident exception for
foreign currency gain or loss recognition.
Mining bitcoin. A taxpayer who successfully
mines bitcoin recognizes gross income equal to the FMV of the bitcoin on the
date of receipt. The FMV of bitcoin received must be reported in U.S. currency
as of the date of receipt. Notice 2014-21 says that if virtual currency is
listed on an exchange and the exchange rate is established by market supply and
demand, the FMV is determined by converting the virtual currency into U.S.
dollars at the exchange rate “in a reasonable manner that is consistently
applied.” The exact manner to be used (e.g., highest daily value, average daily
value, lowest daily value) is not described. Taxpayers should be able to use a
method that minimizes income recognition as long as the method is applied
consistently.
Information reporting. A payment made with
bitcoin is subject to information reporting to the same extent as any payment
made in property. Any person who, in the course of a trade or business, pays
$600 or more to a U.S. nonexempt recipient is subject to information reporting.
The value of bitcoin is aggregated with other currency when determining whether
the $600 threshold is met. A person in a trade or business who pays $600 or
more to an independent contractor for the performance of services is required
to report the income on Form 1099-MISC. Payments using bitcoin should be
reported using the FMV as of the date of payment. Payments made using bitcoin
are subject to backup withholding to the same extent as other payments. Payors
using bitcoin must solicit a taxpayer identification number (TIN) from the
payee and backup withhold if a TIN is not obtained prior to payment.
FBAR and FATCA disclosure. Whether bitcoin
must be disclosed under the Bank Secrecy Act or the Foreign Account Tax Compliance
Act (FATCA) is unresolved. IRS informally stated that U.S. taxpayers are not
required to report bitcoin on FBAR for 2013 but acknowledged that it is
continuing to analyze virtual currency and this policy could change in the
future. It has not indicated whether bitcoin will be subject to FBAR reporting
in 2014. Most bitcoin brokers and exchanges accept deposits in the ordinary
course of business and meet the definition of a financial institution for FATCA
purposes. For both FBAR and FATCA reporting, tax practitioners should consider
a conservative course of action and recommend disclosure in appropriate
situations.
Conclusion. Bitcoin is treated as property
for tax purposes, but that treatment is the beginning of the analysis, rather
than the end and several issues remain unsettled. IRS will likely address the
unsettled tax aspects of bitcoin and other virtual currency in future guidance.
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