The use of digital currencies, such as bitcoin, is growing. Between July and December, 2013, bitcoin usage increased by over 75% – from about 1,700 transactions per hour to over 3,000. In the same period, the market value of bitcoins in circulation rose from about $1.1 billion to $12.6 billion. However, the IRS has yet to issue specific guidance addressing the tax treatment or reporting requirements applicable to digital currency transactions. Unanswered questions may include:
1. When will receiving or using digital currency trigger gains and losses?
2. When will these gains and losses be taxed as ordinary income or capital gains?
3. What information reporting, withholding, backup withholding, and recordkeeping requirements apply to digital currency transactions?
4. When should digital currency holdings be reported on a Report of Foreign Bank and Financial Accounts (FBAR), or Form 8938, Statement of Specified Foreign Financial Assets?
Taxpayers are speculating on the Internet about the answers to these questions. Some of this speculation is incorrect, incomplete, or misleading. It is the government’s responsibility to inform taxpayers about the rules they are required to follow. The IRS should issue guidance that addresses the tax treatment and information reporting required in connection with digital currency transactions, including answers to the basic questions listed above.
So let’s look at the two basic questions regarding Bitcoins: How are they taxed, and what reporting is required when using them.
Let’s cover the very first issue: If you make money with Bitcoins, it is absolutely taxable. The US Tax Code is quite simple in that respect: Everything is taxable unless Congress exempts it, and nothing is deductible unless Congress allows it. If you make money with Bitcoins, it is absolutely taxable.
The next question is how are gains taxed, and here is the major issue that the IRS and the courts have yet to decide. Are Bitcoins going to be regulated as a foreign currency or will they be treated like a capital asset? The problem for the IRS is that Bitcoins share features of both but also lack features of both.
Foreign currencies (such as the Euro and the British Pound Sterling) are defined in the US Tax Code; generally, income from foreign currencies is ordinary income under Section 988 of the Tax Code. The problem is that there’s nothing foreign about Bitcoins; they haven’t been issued by any government.
So maybe they should be taxed as a capital asset? But most capital assets can be held, and there’s nothing tangible about Bitcoins. A Bitcoin is ethereal but it has real value. If a Bitcoin is a capital asset, every time you sell a Bitcoin you have a capital gain or loss, and Bitcoins would follow capital gain rules and gains would be preferentially taxed.
Unfortunately, how Bitcoins are taxed is a major question that needs to be answered. Until the IRS comes out with guidance, tax professionals must make guesses.
The best tax summary I’ve found on Bitcoin and taxes is from Tyson Cross, a tax attorney in San Diego. A few of the points he makes that I agree with:
1. Gains are taxable when realized. This is absolutely clear under the US Tax Code. If you accumulate Bitcoins and sell them, use them to buy stuff, or trade them for things, you have gains.
2. The basis for a Bitcoin when it is “mined” is unclear.
3. If you keep Bitcoins on a foreign exchange, you may have to report your Bitcoins on an FBAR (Report of Foreign Bank Account, Form 114 (formerly Form TD F 90-22.1)).
Mr. Cross gets into quite a bit of detail on these issues, and his reasoning. If you are active in Bitcoins, I strongly advise reading the article.
One thing that he notes repeatedly (and I agree with) is that every time you use a Bitcoin, you have a taxable transaction and a gain or loss on that Bitcoin. It’s one thing to buy and hold Bitcoins; it’s quite another to be accumulating and using them actively. If you do so, your recordkeeping for your tax returns will need to be quite extensive.
Something that Mr. Cross does not cover (except for the FBAR) but is mentioned by Nina Olson are information reporting requirements with Bitcoin. I expect the IRS to mandate reporting of Bitcoin transactions similar to how dollar transactions are reported. It would not surprise me to see a heightened requirement for Bitcoin reporting (the IRS might consider Bitcoins as a means around the US financial system).
So how and when will the IRS rule on Bitcoins? It’s the government, so the ruling will come…eventually. I could only guess as to how they’ll rule. My instinct is that they’ll rule that it’s a foreign currency because that would tend to increase tax collection (Bitcoins would be taxed as ordinary income rather than as capital gains). Unfortunately, that’s only a guess.