Whenever bitcoin is bought, sold, or traded, there are tax impacts. We’ll discuss how bitcoins and other forms of virtual currency are taxed, and point out record keeping requirements and tax planning techniques that can be utilized. At the end you’ll find resources for continuing your own research.
The big picture:
“The key thing going forward is maintaining records, substantially similar to stock,” says Jason Tyra, a certified public accountant in Texas who specializes in bitcoin; “Incomplete records might as well be no records.”
Why is record keeping such an important topic? Maintaining records is essential for accurately measuring bitcoin-related income.
When it comes to taxes, the Internal Revenue Service has ruled that bitcoins and other “convertible virtual currencies” are “treated as property” and not treated as currency. This concise guidance from the IRS has implications for how bitcoins are taxed, what information is needed to make sure taxes are calculated correctly, and what tax planning techniques people can use to minimize their taxes on Bitcoin transactions. In brief,
- Virtual currencies are property for tax purposes;
- That means, you’ll have capital gain or loss when disposing of virtual currency;
- Income is taxable, even if you are paid in virtual currency;
- Spending virtual currency is really two transactions in one: disposing of the virtual currency and spending the dollar-equivalent amount;
- Business transactions in bitcoin are subject to all the normal rules for sales tax, withholding, and information reporting;
- Keeping detailed records of transactions in virtual currency ensures that income is measured accurately.
What is Virtual Currency from a Tax Perspective? Here’s What the IRS Has to Say
- “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”
- Virtual currency “does not have legal tender status in any jurisdiction.”
- “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.”
- “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.”
- “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.”
Virtual Currency Treated as Property – That Means Capital Gains When Bitcoins are Disposed
“Every bitcoin transaction is taxable,” writes Tyson Cross, a tax attorney who specializes in virtual currencies. “Bitcoin users will have to calculate their gain or loss every time they purchase goods or services with bitcoin.”
Let’s think for a moment about what this means. The IRS said that bitcoin and similar convertible virtual currencies are property for tax purposes. As with other types of property, first one acquires property, often by exchanging cash for the property. Then one owns the property for a period of time. And then eventually one might sell or give away or trade or otherwise dispose of the property. So with any type of property we have three moments in time: acquiring the property, holding the property, and disposing of the property.
The same three aspects are found with convertible virtual currencies.
Let’s start by discussing 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, four things happen:
- Income is realized from any gains on the property.
- 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. These forms require us to “show our math” when calculating gain or loss.
Tax Tips for Merchants & Businesses
- Identify an exchange rate to use consistently in valuing bitcoins received.
- Charge sales tax when a customer buys from you using bitcoin, if that’s required in your line of business.
- When paying an independent contractor $600 or more during the year, request Form W-9 and issue Form 1099-MISC, even if you pay them in bitcoin. Track the amount paid to contractors throughout the year to measure whether you reach the $600 threshold. Backup withholding may be required.
- If paying employees in bitcoin, first withhold all applicable payroll taxes in US dollars. Net pay can then be paid out in bitcoin as appropriate.
- Taxes are paid in dollars, not in bitcoin. Consider converting bitcoins to dollars on a regular schedule so that you have enough dollars to remit any income tax, withholding, or sales tax.
- Include bitcoin transactions when figuring your estimated tax payments.
- Sales revenue is recorded as business income in dollars.
- Expenses are also recorded in dollars.
- Gain or loss on holding bitcoin are recorded as trading gains (Form 4797 or Schedule D as appropriate)
There are some non-tax related best practices for merchants:
- “Most merchants are converting virtual currency at the time of the transaction or shortly thereafter, since they aren’t in the business of taking risk on bitcoin’s price volatility,” says David Berger, founder and chief executive officer of the Digital Currency Council, which provides training on digital currency for accountants and attorneys.
- There are merchant service providers who guarantee the exchange rate at the time of sale and provide daily automatic conversion of bitcoin to dollars, Berger mentioned.
- Compare bitcoin fees/commissions and processing times with other payment technologies (such as merchant accounts, PayPal, etc.).
Tax Tips for Casual Bitcoin Users
- Establish a record-keeping system.
- Keep track of when you acquire and when you dispose of bitcoins.
- Record dispositions of bitcoins on Schedule D and Form 8949.
- Each purchase using bitcoin is two transactions in one: an implied disposition and an expense.
On a non-tax note, casual bitcoin users will want to use a reputable bitcoin wallet provider. Reputable wallet providers have implemented risk mitigation tools to make buying, trading and selling bitcoins more secure and user-friendly, notes David Berger.
Tax Tips for Bitcoin Investors and Speculators
- Establish a record-keeping system.
- Record dispositions of bitcoin on Schedule D and Form 8949.
- Identify your cost basis method.
- Identify your exchange rate.
- Keep separate wallets for short-term trading, long-term buy-and-hold positions, and personal spending.
- Normal capital gains strategies apply: offset gains with losses, time dispositions to qualify for long-term treatment, harvesting losses, and harvesting gains.
- Watch the tax rates: gains subject to the 3.8% net investment income tax.
- Identity the tax treatment for bitcoins received by “mining” them – may be business income subject to the income tax and self-employment tax.
- Deduct any investment-related expenses (Schedule A).
- Deduct any investment interest (Schedule A).
- Deduct tax preparation and advisory fees related to determining the tax treatment of bitcoins (Schedule A).
- Elect Market to Market trading? This would mean all gains are short-term and reported on Form 4797, and any bitcoin-related expenses are deducted on Schedule C.
Apart from tax considerations, investors should take a look at wallet providers or registered investment vehicles with security features one might expect from a banking institution. Some platforms offer to “insure holdings or store holdings offline in a vault,” says David Berger.
Software Tools for Tracking Bitcoins
- LibraTax: Web-based software for importing bitcoin transactions and calculating gains/losses.
- BitcoinTaxes:Web-based software for importing data and calculating gains/losses.
- PayByCoin add-on for Quickbooks Online customers for merchants to accept payment via bitcoin and reconcile the data inside the online version of Quickbooks.
Tax and Accounting Articles about Bitcoin
- Jason Tyra, CPA, has written extensively about bitcoin at Bitcoin Magazine, BitcoinTaxBlog and CoinDesk.
- Annette Nellen takes an in-depth look at the IRS guidance in “Bitcoin Taxation: Clarity and Mystery,” (June 12, 2014).
- In Bitcoins Update (10/11/14), Jack Townsend provides a summary of how the IRS is “gearing up for criminal tax investigations” involving bitcoin.
- Deloitte has produced an infographic describing the pros and cons of bitcoin.
- Jessica Bruno describes how bitcoins are taxed in Canada in her article, What to Do with Digital Currency? (Advisor.ca).