Tax Treatment of Bitcoin and other Virtual Currencies
In 2009, the world was introduced to Bitcoin, an internet-based currency which allows holders of Bitcoin to purchase goods and services from those who accept it as a form of payment. Bitcoin is a cryptocurrency, which means that it is not issued by a central authority, such as a government or a central bank, and is not recognized as legal tender. Instead, the value of Bitcoin, along with other similar virtual currencies, stems from the belief by those who use it that the currency will maintain its value over time. Bitcoin employs a decentralized network of computers to record transactions in the form of a blockchain, which is a transparent, publicly available distributed ledger. Computers on the Bitcoin network each have a continuously updated copy of the ledger containing all Bitcoin transactions, ensuring an accurate accounting of Bitcoin balances even without a centralized authority to oversee the process. So, unlike when a credit card is used to purchase an item, there is no third-party such as a bank to record and privately store information about the transaction.
Since its inception, Bitcoin has seen exponential grown. As of 2020, at least one-third of small and medium-sized businesses accepted Bitcoin as a form of payment, and many large companies, such as Microsoft, AT&T, and Overstock, do as well. At the same time, the market value of Bitcoin has skyrocketed. From being valued in 2010 at a fraction of a dollar, the price of a single bitcoin rose to over $44,000 by February of 2021. Along with its increasing acceptance, several reasons seem to explain the rise in Bitcoin’s value. Bitcoin’s cryptography reduces the risk of hacking, bolstering confidence in the security of the currency. The blockchain offers a transparent and efficient mode of recording and approving transactions without the use of an intermediary and associated fees. Likewise, Bitcoin and others are bolstered by the belief that decentralized virtual currencies are less susceptible to government regulation and manipulation of the money supply.
With the increasingly high market value, Bitcoin has become primarily an avenue of investment rather than just a means of transaction. This presents important challenges for tax authorities when determining how the use, purchase, or sale of Bitcoin and other virtual currencies is to be assessed for tax purposes from a legal perspective. After several years of not addressing the issue, in 2014, the IRS issued a notice which explains “how existing tax principles apply to transactions using virtual currency.” The IRS acknowledged that while virtual currencies can operate like “real” currencies and be used to pay for goods and services, such virtual currencies are not legal tender and will be treated as property rather than currency for federal tax purposes. This determination is key to understanding how transactions involving virtual currencies are taxed and how they are reported on tax returns.
When foreign currency is received as part of a transaction or a currency exchange, the currency is treated as ordinary income. The value of the currency is translated into US dollars, and taxes on the currency are paid as part of income taxes. If the value of the foreign currency held by an individual increases relative to US dollars, taxes are not paid on those gains as long as they stem from personal transactions and the gain is not more than $200. This means if you exchange US dollars for foreign currency while on vacation, for example, you are not responsible for paying taxes on any gains realized if the foreign currency increases relative to the dollar while you hold it.
However, the IRS decided to treat virtual currencies as a form of property rather than currency, making them capital assets like stocks or bonds, which are subject to capital gains tax. Profits from sales of capital assets are taxed as capital gains. Growth on investments held for over one year are considered long-term capital gains and taxed more favorably, but they are taxed nonetheless. This means that owners of Bitcoin will pay taxes on any gains they realize when they dispose of Bitcoin, just as they would if they sold stocks.
To illustrate, suppose you bought Bitcoins valued at 5,000 dollars, then decided to sell your Bitcoin two years later when those same Bitcoins were worth 15,000 dollars. The gain of 10,000 dollars in value between the time you acquired Bitcoin as an asset and the time you sold it is taxed at the capital gains rate. Since capital gains tax only applies when the gains from an asset are realized, the purchase of Bitcoin does not in of itself incur tax obligations until the Bitcoin are sold.
However, capital gains tax does not only enter into the picture when an investor cashes out on a Bitcoin investment. Since virtual currency is not recognized as a legal currency, using such currency for ordinary transactions is also considered a potential capital gain. Unlike recognized currency, the use of virtual currencies to pay for goods and services is considered a disposition of a capital asset, just as it would be if virtual currency was sold on an exchange for US dollars. To calculate the capital gain involved in the transaction, the value of the currency on the date it was acquired is subtracted from the fair market value of the goods or services received in exchange. If the purchased product is worth more than the purchaser’s cost basis in the virtual currency, the difference between the two is taxed as a capital gain.
Finally, while the purchase of virtual currency is not subject to the capital gains tax, the acquisition of virtual currencies can be considered ordinary income subject to general income tax.
This can happen in several ways. Virtual currency received in exchange for goods or services is taxable income, and the fair market value of the currency in US dollars must be included in the computation of the receiver’s gross income.
Likewise, if an employer pays an employee in virtual currency, the fair market value of the currency is considered taxable income. Employers must report such earnings on W-2 forms, and the wages paid are subject to the same tax withholding as they would if paid in dollars.
A third way in which gaining virtual currency is considered income has to do with how new Bitcoin are introduced into the Bitcoin network. While there is no central authority which issues Bitcoin, new Bitcoin can be “mined” in a process that involves using computer software to validate Bitcoin transactions and maintain the public ledger. Those who successfully complete the mining process earn Bitcoin in exchange. The fair market value of the virtual currency earned in this manner is likewise taxable and must be reported as part of gross income.
To summarize, the IRS treats virtual currencies as capital assets, meaning that capital gains tax must be paid on proceeds from the sale of Bitcoin. Moreover, Bitcoin received for work or services provided is income as though one had earned dollars or other currency in exchange for work.
This area of law will no doubt evolve as virtual currencies become more ingrained in our economy and monetary system. But for now, the uncertain status of virtual currency in tax law is something that holders and users of virtual currencies must face.