The Tax Implications of Bitcoin

Bitcoin, the decentralized digital currency that has taken the financial spotlight this year, has yet to become regulated by the government, but that hasn’t stopped the IRS from dictating tax treatment on them.

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You can purchase items, invest, save, mine and even trade bitcoins, and the IRS has ruled that these transactions should be treated as capital assets .

Jake Benson, founder and CEO of LibraTax, the maker of a software product that can help track virtual currency transactions for tax purposes, states, “It’s a decentralized protocol. There is no single entity that controls the money supply.”

The IRS views virtual currency as just another means of facilitating taxable transactions. “Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is one example of a convertible virtual currency,” the IRS wrote in its clarification. “Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.”

With this new currency come tax compliance issues. If you engage in a taxable transaction using Bitcoin, you are required to declare it on your tax return. So let’s say that using bitcoin you purchase stock in a company for 3 bitcoins (exchange rate at purchase is 3 bitcoins equals $1,500 USD). Later you sell the stock for 4 bitcoins or $2,000 USD. Your basis in that stock would be the dollar value of the bitcoins on the date of purchase of the bitcoins and sale price will be the USD equivalency of the bitcoins received on the date of the sale. In this example, you will translate the bitcoin value to U.S. dollars and show a capital gain of $500 on Schedule D of your income tax return in the year of the sale.

The IRS says, “The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets. A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.”

Mining bitcoin has become a popular activity—and the IRS has indicated that this is also a taxable event. Mining for one’s own account can be considered a trade or business and therefore declarable on Schedule C and subject to self-employment tax.

If you are an independent contractor and take your pay in virtual currency, it is subject to income tax and self-employment tax. The payer will be required to issue a 1099 to the independent contractor for the US dollar equivalent of the payment made by virtual currency.

Benson calls the concrete directives from the IRS on bitcoins a good thing. “Ultimately, it means that digital currency is being taken seriously, as are the foundational concepts of cryptocurrency technologies such as public ledgers. The end game here is a fully digital economy that improves convenience, efficiency and governance. Eventually, it will be possible to automatically populate your income, itemized deductions, and business expenses directly from public ledgers.”