How Are Bitcoin and Other Virtual Currencies Taxed?
Bitcoin and other virtual currencies are no longer a novelty, but many individuals and companies are unaware of the federal and state tax ramifications of using them in transactions. It might seem hard to believe, but bitcoin has been around for a decade and the IRS laid out the rules for reporting and taxing the profits and losses that result from virtual currency transactions almost six years ago.
IRS is Already Investigating Virtual Transactions
While many of those who have invested in virtual currencies did so to keep their investments secret from the government, that secrecy is not guaranteed and the IRS has begun to take action against those who have failed to report their profits from trading in virtual currencies. For example, in 2017 the IRS forced the Coinbase cryptocurrency exchange to hand over its transaction records for more than 14,000 customers who participated in bitcoin transactions valued at more than $20,0000. The agency then notified 10,000 taxpayers in July 2019 that the IRS suspected them of having failed to report income resulting from those transactions.
Such IRS enforcement actions may make those participating in virtual currency transactions nervous, but the agency treats the purchase and sale of virtual currencies the same as other property transactions resulting in a capital gain or loss, which means reporting a loss on the sale of bitcoin can have tax benefits for some traders. Most of the news coverage related to bitcoin has focused on its exponential increase in value since its introduction, but experienced traders remember that some of those steep increases in value were followed by equally steep declines. For example, the bitcoin buyer who purchased a single bitcoin for nearly $20,000 at the market peak in December 2017 and sold when the price dipped to slightly more than $3,400 in February 2019 could use those losses to offset capital gains from other investments.
Finally, an increasing number of businesses, in the Bay Area, have begun using bitcoin as part of their day-to-day business activities, so bitcoin and other virtual currency transactions are beginning to appear in general ledgers that may be reviewed by auditors. If unreported bitcoin profits are discovered during a routine audit of your company’s books, it is likely the IRS will begin asking additional questions.
IRS Says Virtual Currencies are Property
The IRS issued a notice in 2014 (Notice 2014-21) which outlined in general terms how the agency planned on treating virtual currencies for tax purposes. Among other things, the notice lays out the IRS’s position that for federal tax purposes, virtual currency is to be treated as property. That means the agency will be applying the general tax principles for property transactions to virtual currency transactions.
Notice 2014-21 also specifies that taxpayers who receive virtual currency as payment for goods or services must include the fair market value of that currency in US dollars in their computation of gross income. That fair market value is to be determined on the date the taxpayer receives the virtual currency using the exchange rate, if the currency is listed on an exchange. If it is not listed, then the exchange rate is determined using the market for that virtual currency if the taxpayer does so in what the IRS determines to be a reasonable, consistent manner.
Finally, the notice specifies that employees who are paid in virtual currency will be treated as having received wages equal to the fair market value of the currency at the time it is received. That also means that the fair market value of the virtual currency received as wages should be subject to federal income tax withholding, the Federal Insurance Contributions Act tax, the federal unemployment tax and must be reported on a form W-2.
Tax Treatment Based on Time Virtual Currency is Held
A taxpayer’s profit or loss from a virtual currency transaction is calculated as the fair market value of the currency at the time it was sold or disposed of minus the fair market value of the virtual currency at the time it was bought, mined or obtained as payment. This means that a taxpayer must keep careful records documenting when a virtual currency was obtained and when it was disposed of.
After the taxpayer has determined whether a virtual currency transaction resulted in a gain or loss, the taxpayer must then determine whether the gain or loss is subject to the rules governing capital gains taxes or those the IRS applies to ordinary income. As a general rule, the IRS treats virtual currencies held for longer than a year as a capital asset that is subject to the rules governing capital gains and those held for less than one year as subject to the same rules as ordinary income. Since capital gains receive preferential tax treatment, it is usually better for taxpayers to hold on to their virtual currencies for at least a year, if possible.
Profits from Bitcoin Mining are Income
The IRS made it clear in Notice 2014-21 that the mining of bitcoin and other “mined” virtual currencies should be included in a taxpayer’s gross income on the day it was mined based on the fair market value of the mined currency. That means individuals who are mining virtual currencies must report their mining proceeds as personal income and do not get the benefit of capital gains tax treatment.
If a taxpayer is running a virtual currency mining operation as a business, then the earnings from mining are considered to be self-employment income that is subject to the self-employment tax
Virtual Currencies Subject to Information Reporting
Payments that are made using a virtual currency must be reported in the same manner as any other payment that is made using property, according to notice 2014-21. In other words, the company or individual making a payment of $600 or more is required to file a federal Form 1099-MISC reporting the payment. Those forms must reflect the fair market value of the virtual currency on the date of the payment.
California Treats Profits from Virtual Currencies as Income
While federal tax authorities allow taxpayers who hold their virtual currencies as a long-term investment the benefits of capital gains tax treatment, California residents will not enjoy the same benefit when it comes to their state taxes. That is because California treats all capital gains, including those resulting from virtual currency transactions, as ordinary income subject to the state’s income tax.
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This post was written by Sean Allaband