The tax treatment of bitcoin and other “virtual currencies”–also known as “cryptocurrencies”–is widely misunderstood. But if one invests in virtual currency, uses it to pay for good or services, or receives it as a payment for goods or services, failure to understand the tax obligations can have serious consequences. This article explains the IRS policies regarding virtual currencies.

On the IRS’s radar

According to the IRS, there are more than 1,500 known virtual currencies, generally defined as “a digital representation of value that functions in the same manner as a country’s traditional currency.” In 2014, the IRS published a notice explaining how existing general tax principles apply to virtual currency transactions. And in a release earlier this year, it reminded taxpayers that income from these transactions is reportable on their tax returns.

Taxpayers who fail to properly report the income tax consequences of virtual currency transactions, the IRS warned, can be audited and, when appropriate, charged with penalties and interest. In extreme cases, taxpayers can be subject to criminal prosecution for tax evasion or filing a false tax return.

The IRS release observes that, “because transactions in virtual currencies can be difficult to trace and have inherently pseudo-anonymous aspect, some taxpayers may be tempted to hide taxable income from the IRS.” Be aware, however, that the IRS has several effective enforcement tools at its disposal. For example, it recently used a “John Doe summons” to obtain information from Coinbase, one of the largest virtual currency exchanges. The IRS requested data about customers who bought, sold, sent or received more than $20,000 of bitcoin in any one year during a period from 2013 to 2015.

Treated as property

The IRS treats virtual currency as property –rather than currency– for federal tax purposes. This has a number of consequences:

  • Taxpayers who receive virtual currency as payment for goods or services must include the currency’s fair market value (FMV) at the time of receipt in their gross income. General, FMV is based on the price quoted on a virtual currency exchange.
  •  virtual currency payments that constitute wags are taxable to the employee, reportable by the employer on Form W-2 and subject to federal withholding and payroll taxes.
  • Virtual currency payments to independent contractors are reportable by the employer on Form 1099 (provided the $600-per-year threshold is met) and subject to income and self-employment taxes. Backup withholding may be required if, for example, the payer doesn’t obtain a taxpayer identification number from the payee.

Many people are surprised to learn that, if you use virtual currency to pay for goods or services, may have to report a taxable gain or loss. Suppose, for example, that you bought 10 bitcoins several years ago for $500 each. Later, when the FMV has reached $5,000, you use them to buy a $50,000 ski boat. Your tax basis in the bitcoins is $5,000, so your taxable gain is $45,000. The nature of the gain depends on whether the bitcoins are considered capital assets and, if so, whether you’ve met the holding period requirement for favorable long-term capital gains treatment.

Get help

If you’ve invested in virtual currency or used it in transactions for goods or services, consult your tax advisor. This professional can help ensure that you meet your tax reporting obligations.

© 2018

Jaime D. Rorie, CPA
Jaime specializes in financial statement audits and other attestation engagements including compilations and reviews of for-profit, non-profit, and government entities. She also conducts audits of employee benefit plans and provides tax return services for individuals, corporations, and non-profits.