More than five years after Bitcoin made its debut, the Internal Revenue Service has finally issued guidance to taxpayers on how to treat it – and other virtual currency – for federal income tax purposes. Their decision? It’s not money. Noting that “virtual currency is not treated as currency that could generate foreign currency gain or loss for US federal tax purposes,” the IRS determined that Bitcoin and similar currencies are to be treated as a capital asset.
The decision to treat Bitcoin and other virtual currency as a capital asset means that capital gains rules apply to any gains or losses. That treatment does have an upside for taxpayers since capital gains rates are generally pretty favorable to taxpayers. This year, for example, capital gains rates for long term gains (those held more than a year) range from 0% to 20%. And losses are really losses: capital losses can be netted against capital gains and the excess losses can be deducted from ordinary income (up to $3,000 each year).
For those buying and selling Bitcoin as an investment, calculating gains and losses are figured the same as buying and selling stock. The basis, the holding period, and even the triggering event (the sale of the asset) are all very clear.
For those treating Bitcoin like cash – from paying for services to buying cupcakes in San Francisco to shopping for patio furniture on Overstock.com – transactions may result in a gain or a loss. And while the triggering event (the transaction) is easily determined, it may be difficult to figure cost basis – or the holding period.
If, however, Bitcoin had been treated as currency then ordinary income would have applied to any gains or losses as a result of fluctuating values. In addition, the net income investment tax (NIIT) might have applied to taxpayers at the top pushing the rate as high as 43.4% (39.6% + 3.8%).
Other countries had already bowed to pressure to clarify the tax treatment of Bitcoin – including, most recently, the UK. Before that, Singapore had announced plans to treat Bitcoin like a product subject to its goods and services tax (neither currency nor pure capital gains) while Germany considered Bitcoin as “personal money.”
The IRS continued to remain silent on the issue even as Bitcoin hit record highs in value. Some investors and taxpayers took matters into their own hands – among them, the Winklevoss twins (yes, the ones from Facebook) who made up their own rules when they filed with the Securities and Exchange Commission for their Winklevoss Bitcoin Trust. At the time, they suggested that “[u]nder one reasonable approach, a Bitcoin should be treated as a capital asset (and not as “currency”).” Prescient? Good guesses? Or excellent advisors? No matter how they arrived at the answer, that treatment ensures that the Winklevoss twins won’t have to amend past returns: today’s guidance takes effect immediately and covers past years. Penalty relief may be available for those taxpayers who took other positions “due to reasonable cause.”
The IRS has also made it clear that normal reporting rules as they relate to bartering, independent contractors, and self-employment tax still apply whether you’re paid in virtual currency or cash.
Finally, the guidance issued today only applies to “convertible” virtual currency. “Convertible” virtual currency is generally defined as a virtual currency that has an equivalent value in real currency or acts as a substitute for real currency (guidance from FinCEN downloads as a pdf).
If, after all of that, you’re trying to do the math in your head, Bitcoin (BTC) was valued on March 25, 2014, the date of the IRS Notice at $578.62; in contrast, at the beginning of December 2013, Bitcoin was valued at $1,200. It will be interesting to see how today’s guidance affects future Bitcoin valuations. While the US doesn’t drive the Bitcoin market, concerns about how the tax treatment might slow down Bitcoin as a viable currency for ordinary transactions in the US are sure to affect trading.
You can read the entire IRS Notice 2014-21, issued today, here (downloads as a pdf).