At long last, the IRS has finally offered some clarity on the federal tax implications of transacting and investing in bitcoins and other virtual currencies. When Naila first discussed this topic in her post of February 19, 2014, which dealt with the taxability of mining bitcoins and the impact on foreign account reporting when bitcoins are held in a digital wallet, the guidance was not formalized or readily available to taxpayers. Things are different now.
In late March, the IRS published Notice 2014-21 which is written as a series of answers to FAQs in quite understandable language. The scope of the Notice includes only “convertible virtual currencies”; that is, currencies that have an equivalent value in “real” currencies or that act as a substitute for real currency.
The primary question has been whether virtual currencies would be considered currency or property, and the answer has significant implications to users of virtual currencies. We now know the IRS considers virtual currencies property for federal income tax purposes. The reason the IRS gives for not treating virtual currencies as currency is that they do not have legal tender status in any jurisdiction.
Here’s an example of what this means:
Suppose you bought 5,000 bitcoins on July 1, 2013 when the price was approximately $93 and then on June 1, 2014 you used those bitcoins to purchase a new home when the price was approximately $613. Since your cost basis was $465,000 (5,000 times $93) and you exchanged the bitcoin for other property with market value of $3,065,000 (5,000 times $613), you now have a taxable gain of $2,600,000. Ouch!!!!!!
But bitcoins aren’t used only for large transactions. You can buy your morning coffee in Palo Alto in bitcoin (or fractions thereof). Try tracking your gain (or loss – it certainly goes both ways!) for day-to-day trivial or even larger consumer transactions. Talk about a recordkeeping nightmare!
The IRS Notice also outlines the tax aspects of mining bitcoins by noting that new bitcoins received from mining operations is includible in gross income.
To summarize a few other matters covered in the FAQs:
- Taxpayers receiving bitcoins in payments for goods or services must include the fair market value of the bitcoins received in computing gross income measured in U.S. dollars based on an exchange rate listed on a bitcoin exchange.
- The type of gain or loss realized on exchange of bitcoins depends on whether the virtual currency is a capital asset to the taxpayer. If not, then the exchange results in ordinary income or loss.
- Virtual currencies used to pay an employee constitute wages to the employee. As such, these amounts are subject to FICA and FUTA and must be reported in the employee’s W-2.
- Since virtual currency is not treated as currency, no foreign currency exchange gain or loss can be generated for federal tax purposes, and no foreign account reporting is required.
Undoubtedly, as virtual currencies become more commonplace and day-to-day transactions mushroom, we would expect the IRS to issue further clarifications on recordkeeping requirements; and third-party record-keepers may emerge to help with managing the details required to comply with the IRS requirements. At the same time, how easy will the IRS have it tracking taxpayers’ virtual currency transactions?
While the position of the IRS regarding virtual currencies is now quite clear, what is not so clear is how the practicalities will play out in the real world.