It seems like Bitcoin is being talked about almost everywhere you go, on the news, radio, TV and numerous blogs on the internet. There is even a new term for people who made millions investing in Bitcoin – Bitcoinnaires!
There are two types of virtual currency – nonconvertible (like Pokémon Go coins) and convertible virtual currency (CVC). Bitcoin, Ethereum, Ripple and other virtual currencies are considered CVCs. CVC is also called cryptocurrency—a reference to the fact that CVC uses software-aided cryptography to control the issuance of new units of currency and to otherwise secure and control transactions.
So how does the IRS treat trading and investing in Bitcoin and other virtual currencies (CVC)?
The IRS began issuing guidance on taxation of Bitcoin back in March 2014. At that time, the agency announced that Bitcoin would be treated as property, with loss or gains being treated as capital loss or capital gains for tax purposes.
In the notice, the IRS make the following observations:
“For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.”
“A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.”
“Transactions using virtual currency must be reported in U.S. dollars” on the tax return.
“Taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt.”
“If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars … at the exchange rate, in a reasonable manner that is consistently applied.”
This means that every Bitcoin transaction is taxable. Bitcoin users will have to calculate their gain or loss every time they purchase goods or services, or sell the currency itself.
So, what happens from a tax perspective at the end when bitcoins are sold or disposed of? Since bitcoins are property, we would follow the rules that apply to dispositions of property. When property is disposed of, income is realized from any gains on the property. Here are the mechanics:
Gain is measured by the change in the dollar value between the cost basis (the purchase price) and the gross proceeds received from the disposition (the selling price).
The tax rates that apply depend on whether the property was held for a short-term or for a long-term duration.
And finally, dispositions of property are reported on the tax return using Schedule D & Form 8949 or Form 4797.
Therefore, it is key to maintain your records like the way you maintain records for stock transactions. You need to track your cost basis and identify an exchange rate to use consistently in valuing bitcoins received or invested.
The Notice does not indicate what type of accounting method should be used with CVC—Last-in, First-out, First-In, First-outor some other method. Moreover, traditional accounting methods are challenging in the CVC context because some CVCs—like Bitcoin—lack specific identification techniques. Unless each individual unit of CVC is housed in a separate “wallet”, accounting for the basis in each individual unit is practically impossible.
We suggest keeping separate wallets for short-term trading, long-term buy-and-hold positions, and personal spending.
Also, normal capital gains strategies apply: offset gains with losses, time dispositions to qualify for long-term treatment, harvesting losses and harvesting gains.
There is also a possibility of 1031 Exchange. Taxpayers can delay the recognition of gain by exchanging property for another like-kind property—a so-called 1031 exchange.
Of course, 1031 exchanges are subject to many rules and limitations—but it is possible that transactions involving CVC could qualify as 1031 exchanges under the appropriate circumstances. However, the Notice does not address whether CVC could be the subject of a 1031 exchange: if, however, CVC is property then it is at least conceivable that it could be the subject of a 1031 exchange.
In summation, Bitcoin and other virtual currencies are treated as property and subject to capital gain rules. Record keeping is key and having the right tax professional to offer you different strategies is essential.