It’s my annual “Taxes from A to Z” series! If you’re wondering whether you can claim wardrobe expenses or whether to deduct a capital loss, you won’t want to miss it.
V is for Virtual Currency.
Virtual currency is a digital payment system. It’s decentralized and is not issued by any government. Even though it’s not backed by the “full faith and credit” of any government – like our dollars, or by gold and silver, it has real value and is used in commerce.
According to the Financial Crimes Enforcement Network (FinCEN’s) regulations, “real” currency is “the coin and paper money of the United States or of any other country that [i] is designated as legal tender and that [ii] circulates and [iii] is customarily used and accepted as a medium of exchange in the country of issuance.” FinCEN defines virtual currency as “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency.”
The form of virtual currency in the United States that has garnered the most notice is Bitcoin. Bitcoin made its debut in 2008 but it wasn’t until 2014 that the Internal Revenue Service (IRS) issued guidance to taxpayers on how to treat Bitcoin – and other virtual currency – for federal income tax purposes.
That guidance, IRS Notice 2014-21, (downloads as a PDF) indicates that Bitcoin and other “convertible” virtual currencies are to be treated as a capital asset.
“Convertible” virtual currencies are generally defined as virtual currencies with an equivalent value in real currency or those that act as a substitute for real currency. In the Notice, the IRS specifically distinguished Bitcoin and other virtual currency from foreign currency, writing that “virtual currency is not treated as currency that could generate foreign currency gain or loss for US federal tax purposes.”
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. Capital gains rates for long term gains (those held more than a year) currently 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 $3,000 each year).
For those taxpayers buying and selling Bitcoin (or other virtual currency) 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 clear.
For those taxpayers treating Bitcoin like cash, a simple purchase may result in a gain or a loss. And while the triggering event (the sale or transaction) is easily determined, it may be difficult to figure cost basis – or the holding period. That doesn’t give you a pass, however: you must still report.
And don’t assume that using Bitcoin to pay for services changes the playing field: normal reporting rules related to bartering, independent contractors and self-employment tax still apply whether you’re paid in virtual currency or cash. This is of particular importance to those who “mine” virtual currency as a trade or business (as compared to an employee); the net earnings from self-employment resulting from those business activities are considered self-employment income and are subject to the self-employment tax.
For more Taxes A to Z, check out:
- A is for Affordable Care Act Reporting
- B is for Back Pay
- C is for Canceled Debt
- D is for Dependents
- E is for Eligible Rollover Distributions
- F is for Fat Finger Error
- G is for GI Bill
- H is for Harvesting Losses
- I is for Investment Income Expense
- J is for Junk Bonds
- K is for Strike Price
- L is for Late Filing & Late Payment Penalties
- M is for Marginal Tax Rate
- N is for NSF
- O is for Over-The-Counter Medications
- P is for Pease Limitations
- Q is for Quid Pro Quo
- R is for Rounding Off
- S is for Simplified Option for the Home Office Deduction
- T is for Tax Treaty
- U is for United States Tax Court