I have been asked several times already this year about taxes on Bitcoin activities. The IRS gave guidance on this in 2014, but like all things tax and IRS, it is a bit complicated. I’m going to try to give a bullet point discussion on cryptocurrencies like Bitcoin to give some general guidance. However, like most tax and investment topics, everyone is different and will be affected differently so always defer to a knowledgeable professional before you jump in.
What it is: Cryptocurrency is a virtual form of currency that is not regulated or issued by any sovereign (government or centrally controlled institution). In fact, it was initially meant NOT to be a currency but rather a peer-to-peer platform. It is managed by data controlled transactions called a block chain that records and stores the ledger of all transactions among the peers.
As the popularity of Bitcoin grew, the IRS realized that many cryptocurrency uses were not appropriately reporting and paying taxes on their activities. IRS Notice 2014-21 was drafted in 2014 by the IRS as guidance for the tax treatment of the industry. In a nutshell, the IRS treats virtual currencies as property – NOT CURRENCY! The exchange of these properties are subject to capital gains treatment – either long or short term. Because it is not tied to any centrally controlled institution of any country, it does NOT qualify for any foreign currency gains or losses.
Mining cryptocurrency is the process of creating blocks in the blockchain and verifying and confirming transactions. Any income received for mining is considered income just as any job or-self employment work and taxed accordingly including paying Self Employment or FICA/Medicare.
Example: lets say I get paid in Bitcoin to do mining activities on January 1, 2017. At the time I received that Bitcoin it was worth $1000. I now have $1000 of earned income for the year that I received it. On June 5, 2017 I decide to purchase goods from a vendor that accepts Bitcoin. On June 5 Bitcoin is worth $2900. I buy his goods. He reports a sale for $2900. I report a capital asset exchange – I have a short term gain of $1900 ($2900 current value less $1000 for my cost basis when I received it that I already paid taxes on). Since I didn’t hold the Bitcoin for over a year I have to pay short term capital gain rates – generally my ordinary tax rate.
Now, if instead I used the Bitcoin on January 2, 2018 I would pay Long Term Capital Gains taxes on the gain as follows: If I am in the 2 lowest tax brackets I pay 0% on my gain. If I am in the top tax bracket I will pay 20% on my gain. If I am in any of the middle brackets my tax rate on the gain would be 15%.
Some additional things you should note:
1. Every use of these virtual currencies triggers some sort of tax event so keep really good records of your buy transactions including date and value as well as your use of these currencies. Keeping really good records is always a good practice!
2. All income and payroll taxes still apply to the use of these currencies if paying for services.
3. 1031 Exchanges do NOT apply to virtual currency.
4. The Financial Crimes Enforcement Network (Fin-Cen) has determined that virtual currency exchanges and miners are money services businesses who are required to register and comply with money laundering rules and practices.
Cryptocurrency is definitely a hot topic lately so be sure to review your activities with your legal and financial professionals.
Want to hash through your Bitcoin experiences and taxes? Comment here or contact us!
We’ll chat again soon!