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Understand the Tax Implications of Using Bitcoins
The taxman cometh.
Through IRS Notice 2014-21, the IRS provides basic information on the U.S. federal tax implications of transactions in bitcoin and any of the more than 200 forms of cryptocurrency.
This IRS notice has immediate implications if you receive bitcoin as payment, use bitcoin as payment, issue or receive bitcoin as wages, or mine bitcoins. Let’s take a closer look at each of these cases.
Receive Bitcoin as Payment
According to the IRS, for federal tax purposes bitcoins are treated as property, not currency. The same general tax principles applicable to property transactions apply to transactions using bitcoins.
Let’s take a look at an example. Mike sells paintings through his website and he decides to start accepting bitcoins in order to increase his online sales. Mary pays him 1 BTC (a total of $500 on that day) for a painting. Mike holds on to the bitcoins for two days before converting them to US dollars. Three possible scenarios may happen:
- On the day that Mike trades his bitcoins, the market price is exactly $500. His transaction is a wash, so he is not responsible for taxes.
- The market price doubled! Mike got $1,000 for his 1 BTC, so he made a $500 profit on his bitcoin trade. He needs to keep track of this and other "unearned income" for the rest of the year, and, depending on the total, he may be liable for taxes.
- The market price tanked! Now Mike got only $250 for his 1 BTC and he incurs a $250 loss. This $250 economic loss is a capital loss and doesn’t offset the $500 ordinary income on the sale of his painting. Mike is still liable for income taxes on the original $500 sale. On the other hand, Mike needs to keep track of this capital loss for the rest of the year, which he can use to offset his capital gains, if any.
Note that these are three very simplistic scenarios, and that things can quickly complicate if Mike were to work also as a bitcoin trader, hold a lot of cash reserves in bitcoins, make capital investments or have expenses to be able to process bitcoin payments, or buy instruments to hedge his exposure against bitcoin’s price volatility.
Use Bitcoin as Payment
What about Mary, the painting buyer from our example? Imagine that she loves so much using bitcoin online, that she constantly keeps a balance of 10 BTC in her wallet.
According to IRS Notice 2014-21, Mary has to keep track of all possible capital gains and losses from all personal transactions, no matter how small. Remember that the IRS deems bitcoin as property, not as currency, so the exemption for up to $200 in transactions in foreign currency doesn’t apply.
Issue or Receive Bitcoin as Wages
Mike’s online gallery is booming and he decides to hire Steve as an independent contractor to pick up the slack. Steve prefers to get paid in bitcoin by Mike.
Both Mike and Steve need to follow rules stated on Form 1099-MISC, Miscellaneous Income. Independent contractors are responsible for applicable income taxes for the equivalent market value of the bitcoins at the time of receipt. Employers of independent contractors must issue Form 1099-MISC as required by law.
If Mike decides to hire Steve as an employee and continue to pay Steve in bitcoins, he needs to issue a W-2 form valuing the bitcoins at fair market value at the time of payment.
To make ends meet, Steve works as a bitcoin miner on a part-time basis. "Miners" are treated as financial services providers, rather than prospectors. This means that miners don’t need to sell their "discovered treasure" to incur income. Mike needs to recognize income at the time he receives his bitcoins, using fair market value. For more information, miners can refer to IRS Publication 525, Taxable and Nontaxable Income.
Bills Action Plan
Here are three important reminders to pay attention to for all bitcoin transactions:
- Whenever you buy or sell a bitcoin to dollars, you need to keep track of your gains and losses. Better safe than sorry!
- The IRS may impose penalties to those that fail to comply with applicable reporting obligations, even if those events happened prior to the issue date of IRS Notice 2014-21, March 25, 2014.
- Bitcoin should be valued at a "fair market value", which is determined in a "reasonable manner" and "consistently applied". Notice the three terms are in quotation marks because the notice provides no guidance as what those are specifically.
What are you doing to meet the requirements set by IRS Notice 2014-21?