I can’t resist the opportunity to discuss the topic of bitcoins. Bitcoin is unfamiliar and uncharted water to many people. The growing use of this virtual currency is definitely expanding. Consumers need to consider what bitcoins are and how they are accounted for and taxed.
The use of bitcoins is being accepted by many companies such as Overstock.com, 1-800 Flowers, and the DISH Network. It is estimated that over 80,000 businesses now accept bitcoins.
The history of bitcoins can be traced back to a computer programmer who used the alias Satoshi Nakamoto in 2009. Bitcoins are created by a mining, a process whereby computers are used to solve complex mathematical problems. Miners who solve these problems are rewarded with bitcoins. A finite number of bitcoins will be produced. The number of bitcoins available to be mined is capped at 21 million and all bitcoins are expected to be mined by 2140. Once created, bitcoins can be sold, traded on an exchange or used to buy goods and services. Bitcoin is a virtual currency and does not have any physical or tangible attributes. Each bitcoin does have a coded internet address to identify it and can be stored in an owner’s digital wallet. Bitcoins are not backed by any bank. Interesting enough they do not incur any processing fees when used. Credit cards generally incur processing fees when used. This may lead to their increased use as well in the future.
There is a company called Bitwage, that operates an International Payroll Company. Bitwage uses bitcoins as a means for processing payroll that reduces international wage payment fees and processing delays. This is just an example of the innovation in the market place and a growing trend toward using bitcoin. Bitcoins can be transferred from computer to computer using cryptographics.
The IRS has provided guidance on the U. S. tax consequences of transactions in, or transactions that use virtual currency such as bitcoin. This guidance is found in Notice 2014-21. This guidance is the beginning for determining what the tax consequences of bitcoins will be. How exciting is this! A completely new topic for discussion has been opened and the IRS is seeking public comments.
According to Notice 2014-21 – virtual currency is treated as property for tax purposes and taxpayers recognize gain and loss on the exchange of virtual currency for other property. As a result, gain or loss is recognized every time that virtual currency is used to purchase goods or services. Well, this even gets more complicated because we have to consider how losses are treated for taxpayers based on the facts for that particular taxpayer. I will try to save you some of the headache but one needs to consider if the bitcoin is used for business transactions, personal transactions or investment and each of the three have different outcomes. If the transaction was performed in a business context, then there can be deductible loss recognized based on the difference between the bitcoin basis and the amount received. If the bitcoins are used for personal transactions, then the taxpayer will have a non-deductible loss. Finally, if the taxpayer holds the bitcoin as an investment then the loss could be considered an investment loss. We are still waiting for further guidance as to distinguishing between personal and investment classification.
In regards to a taxpayer’s basis in virtual currency the default rule for tracking basis will fall be FIFO method but taxpayers can also us LIFO, average method or specific identification. This is an area of extreme importance because this tracking can be used to minimize gain.
A taxpayer’s character of gain or loss (i.e. short term or long term) will depend on first determining whether the virtual currency is a capital asset in the hands of the taxpayer. Thereafter, normal netting processes of short term and long term capital gain transactions would be applied. Note, though that taxpayers with gross income in excess of $200,00 ($250,000 MFJ) would be subject to the 3.8 % net investment income tax.
This gets even more interesting if you consider that virtual currency is not treated as a currency at all for IRS purposes. This is favorable for investors because of the tax rate associated on long-term capital gain transactions. Bitcoin does not fall under the Section 1256 provision which require certain investments such as foreign currency to marked to market and treated as sold on the last day of the year.
We need to recognize though that even although bitcoin is not treated as a currency for IRS Purposes that it has been held to be considered a “form of money” for purposes of the Securities Act of 1933 in a district court’s Securities and Exchange Commission V. Shavers and Bitcoin Savings and Trust case. Also, the Financial Crimes Enforcement Network (FinCen) has stated that it does not distinguish between transmitters of fiat currency and bitcoin and that bitcoin transmitters are required to register with FinCEN and satisfy ongoing recordkeeping and reporting requirements under the Bank Secrecy Act (BSA).
I must mention that value of bitcoins is a volatile market that offers the potential for gain and loss and may not be ideal for the risk adverse investor.
Well, this was a fun topic to blog about and believe me a topic that needs much more analysis and application to each individual investor. Please contact our office to discuss your bitcoin transactions and we can offer further assistance.