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Do I have to pay taxes on Bitcoin gains?

You’ve probably heard of Bitcoin. They are by far the best known and most widely used convertible virtual currency. If you ever use it, be sure to understand what Bitcoin taxes you may have to pay.

What is Bitcoin?

Bitcoin is an online digital currency. This form of electronic cash is created at a predetermined rate via an open source computer program that began running in 2009. There is no physical Bitcoin.

Each Bitcoin consists solely of a coded Internet address that can be stored in an online “wallet” created by each Bitcoin owner. The digital currency is created by “mining.” This a process in which computers are used to solve complex mathematical problems. Only a finite number of Bitcoin can be created.

Once created, Bitcoin can be sold, traded on an exchange, or used to buy goods and services. The value in a traditional currency like dollars is not fixed by a bank or anybody else and can fluctuate wildly on the online exchanges.

Bitcoin is not backed or regulated by any government, central bank, or other legal entity. Thus, no one has to receive cryptocurrency as payment for goods or services. Yet, tens of thousands of merchants are accepting them. Some people are even getting paid for their services in Bitcoin.

Bitcoin can also be directly transferred anonymously across the Internet. This anonymity can make it a cheap way to settle international transactions because there are no bank charges to pay or exchange rates involved. It is also an attractive way to purchase illegal goods or launder unlawful money.

Bitcoin is not money for tax purposes

Although Bitcoin can be used as currency, they are not considered to be money (legal tender) by the IRS or any other country. Instead, it is personal property, much like gold or corporate stock.

The value of a Bitcoin for U.S. tax purposes (“basis” in tax speak) is its fair market value in U.S. dollars on the date it is received. (IRS Notice 2014-21) Any transaction fees are added to the Bitcoin’s basis.

Unless you’re in the business of buying or selling Bitcoin, they are a capital asset. Your gains when you use them are taxed at capital gains rates (which are lower than regular individual tax rates if the property is held for more than one year). Losses are deductible only if Bitcoin is used for business or investment purposes; investment losses are limited to $3,000 per year. IRS Form 8949 is used to report capital losses and capital gains.

It’s important to keep accurate track of your basis in the Bitcoin you purchase. Each Bitcoin purchase should be kept in a separate online wallet. There’s software is available to help you with the recordkeeping.

Buying stuff with Bitcoin

Anytime you use Bitcoin to purchase goods or services, a gain or loss on the transaction is recognized. You determine whether you have a profit or loss by subtracting your basis in the Bitcoin from the value of the goods or services you purchase with them.

Example: On 3/1/16, Joe purchased 1 Bitcoin for $1,000. Fourteen months later, he uses this Bitcoin to buy $1,250 worth of merchandise. He has a $250 gain on the transaction ($1,250 amount realized – $1,000 basis in one Bitcoin = $250 gain). The $250 gain is a tax-favored, long-term capital gain to Joe because he held the Bitcoin for more than one year.

Theoretically, you recognize a taxable gain (or possible deductible loss) even when you use Bitcoin for small transactions, such as buying a cup of coffee or a digital song download.

If you use Bitcoin to purchase something for your business, you can ordinarily deduct the cost. For example, if Joe from the case above purchased a $1,250 computer for his business with his Bitcoin, he can deduct the expense. But he would get no deduction if he bought a $1,250 television for his personal use.

Selling stuff for Bitcoin

If you sell goods or merchandise for Bitcoin, your gain or loss is the fair market value of the Bitcoin received less the adjusted basis of your property given up. Your basis in the Bitcoin is their fair market value at the time of receipt.

Example: Arnie sells an antique rug for Bitcoin valued at $1,000 on the date of the sale. He paid $500 for the carpet, so he has a $500 capital gain. His basis in the Bitcoin is $1,000.

Getting paid in Bitcoin

If Bitcoin is received as payment for services, it is considered taxable income and will be subject to both income and Social Security and Medicare taxes. The amount of such income is based on the fair market value of the Bitcoin in U.S. dollars on the date you receive them.

Bitcoin tax example

Julie, a freelance consultant, bills a client $5,000 for her services. Instead of paying her in dollars, the client pays her 5 Bitcoin. The Bitcoin exchange rate at that time is $1,000 per Bitcoin. Julie’s basis in the Bitcoin is $5,000. She must report this amount as income on her tax return.

If an employee is paid in Bitcoin, the employer must still pay and withhold income and employment tax from the compensation in U.S. dollars.

Converting Bitcoin to cash

Bitcoin value can appreciate. When you convert Bitcoin to cash, you subtract your basis in the Bitcoin from the amount of cash received to determine if you have a taxable capital gain or loss. You’ll minimize any profit or loss if you sell your Bitcoin soon after you acquire them. Plus, you won’t have to track their basis.

Most taxpayers are not following the rules

The IRS recently revealed in a court filing that only 802 taxpayers reported transactions likely involving Bitcoin in 2015. This find undoubtedly represented only a tiny fraction of all the people who used Bitcoin that year. So, it’s clear that most people who use Bitcoin are not following the tax rules described above.

The IRS has begun an investigation into tax evasion involving Bitcoin. Last year, it demanded that Coinbase, the largest Bitcoin exchange in the U.S., turn over the records of all customers who bought Bitcoin from the company from 2013 to 2015, and whose accounts engaged in transactions worth $20,000 or higher.

Coinbase claimed the IRS’s demands were illegally broad and refused to comply. The IRS has filed a federal lawsuit to enforce the summons.

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Business Insights and Ideas does not constitute professional tax or financial advice. You should contact your own tax or financial professional to discuss your situation.