AT&T T, +1.00% recently announced that its customers can use bitcoin to pay their phone bills. Microsoft MSFT, -0.68% , Expedia EXPE, +0.12% , and Overstock OSTK, +4.71% , among other big companies, also accept bitcoin. Bottom line: virtual currency has gone mainstream. However, using virtual currency has tax implications that may surprise you and the IRS is on the case.
In fact, virtual currency transactions are a hot-button issue with the IRS, and you can understand why. Coinbase claims it has now has over 30 million accounts. But in 2013-2015, fewer than 1,000 e-filed federal income tax returns reported transactions that appeared to involve virtual currencies. Hmmm. In response to this seeming contradiction, the IRS forced Coinbase to turn over information about 14,000 of its customers, the Wall Street Journal reported.
In July the IRS announced it has begun sending letters to taxpayers that may have failed to report income from virtual currency transactions or that may have failed to report their transactions properly.
Here are some FAQs and answers on virtual currency and your taxes.
What is virtual currency?
Virtual currency is “digital money” that’s usually issued and controlled by software developers and accepted as payment by willing parties. Virtual currencies are also sometimes called cryptocurrencies.
In 2014, the European Banking Authority described virtual currency as a “digital representation of value” that is not issued by a central bank or public authority but that is accepted by some as a means of payment. In other words, virtual currencies are unregulated — unlike currencies issued and controlled by governments and central banks.
Virtual currencies can be transferred, stored or traded electronically.
Bitcoin BTCUSD, -1.33% is the best-known virtual currency. You can use it and other virtual currencies to make online payments to willing providers of goods and services. You can also hold virtually currencies for speculative investment.
What are the basic tax implications of using virtual currency?
The IRS takes the position that virtual currency is “property” for federal income tax purposes. (Source: IRS Notice 2014-21.) Unfortunately, that means you are supposed to recognize taxable gain or loss every time you exchange virtual currency for goods or services or for good-old U.S. dollars.
If you fail to report virtual currency transactions on your tax returns and get audited, you could face interest and penalties and or even criminal prosecution in extreme cases. Yikes. Who knew?
Depending on the circumstances, a virtual currency holding can be classified as business property, investment property, or personal-use property.
How do I translate virtual currency into U.S. dollars for tax purposes?
Calculate the fair market value (FMV), measured in U.S. dollars, of the currency as of the date you receive it. The values of the most-popular virtual currencies are listed on exchanges. For example, bitcoin and three other virtual currencies are listed on the Coinbase exchange.
To calculate the FMV of virtual currency, convert it into U.S. dollars using the listed exchange rate. For example, at the time this was written, 1 bitcoin translated into $9,948.95. Or $1 translated into 0.000101 bitcoin. If you bought one bitcoin with U.S. dollars at this price, your tax basis in the bitcoin would be $9,948.95.
What if I use virtual currency to buy stuff?
When you exchange virtual currency for other property (including U.S. dollars), you must recognize taxable gain or loss.
You will have a taxable gain if the FMV of the property you receive exceeds your basis in the virtual currency.
You will have a taxable loss if the FMV of the property you receive is less than your basis in the virtual currency.
If the virtual currency was held for investment purposes for more than one year, any gain will qualify as lower-taxed long-term capital gain.
Example 1: You use 1 bitcoin to buy computer equipment and software for your small business. On the date of the purchase, bitcoins are worth $9,500 each according to Coinbase. So you spent $9,500 on depreciable business computer equipment and software. Fair enough.
But you bought the bitcoin a few months earlier for only $9,000. So you also have a $500 gain from the appreciation in value of the bitcoin ($9,500 − $9,000) that you exchanged for the business assets. Since you are not in the trade or business of buying and selling bitcoins, the $500 gain is a capital gain (short-term or long-term depending on how long you held the bitcoin).
What if I use virtual currency to pay workers in my business?
If you use virtual currency to pay employee wages, the FMV of the currency counts as wages subject to federal income tax withholding, FICA tax, and FUTA tax. Like any other wages paid to employees, you must report the wages on Form W-2.
If you use virtual currency to pay an independent contractor for performing services for your business, the FMV of the currency is subject to self-employment tax for the contractor. You are required to report the payment on Form 1099-MISC if payments to that contractor during the year amount to $600 or more.
You may also have a gain or loss due to appreciation or decline in the value of the virtual currency during the time you held it before paying it out as wages or for services from an independent contractor. Since you are not in the trade or business of buying and selling virtual currencies, the gain and loss will be a capital gain or capital loss (short-term or long-term depending on how long you held the virtual currency).
What if I accept virtual currency as payment for stuff of services?
Here’s what happens, tax-wise.
Example 2: You sell a valuable piece of antique furniture that you bought and lovingly restored for 3 bitcoins. On the date of sale, bitcoins are worth $9,900 each according to Coinbase. Your tax basis in the piece is $20,000. You must recognize a $9,700 taxable gain on the deal: ($9,900 x 3) = $29,700 sale price for the piece - $20,000 tax basis = $9,700 gain.
Example 3: You accept 2 bitcoins as payment for services rendered as an independent contractor. On the date of receipt, bitcoins are worth $10,000 each according to Coinbase. So you must recognize $20,000 of taxable income ($10,000 x 2) for services rendered. And you will probably owe self-employment tax on the $20,000 too.
Which virtual currency transactions are likely to attract the attention of the IRS?
Some 60% of global Bitcoin transactions were for less than $600, according to Coin Metrics, a virtual currency data provider. The IRS is unlikely to focus its guns on small players. So most folks have nothing to fear. The agency is more interested in tracking down individuals and businesses that engage in significant virtual currency transactions while failing to comply with the tax rules. For instance, those who earn significant unreported profits from speculating in virtual currencies, businesses that collect significant unreported revenue from virtual currency sales, and businesses that pay significant amounts to independent contractors using virtual currency and fail to file 1099s are the types of tax scofflaws the IRS has in its cross-hairs.
For most folks, the tax rules for virtual currency transactions fall into the “Who Knew?” category. But the IRS doesn’t usually accept that as an excuse, and the agency is on the prowl for virtual currency tax scofflaws. You don’t want to get caught in the net. So it’s important to maintain detailed records of your virtual currency transactions. The records should summarize: (1) when the currency was received, (2) the currency’s FMV on the date you received it and the exchange used to determine that, (3) the purpose for holding the currency, and (4) the FMV of the currency on the date you exchanged it for something else (including U.S dollars) and the exchange used to determine that.
With this information, you can figure the tax consequences of your virtual currency transactions and keeping records of this information will serve you well if you get audited.