Below is an excerpt from a white paper published by LibraTax. The full white paper entitled “Introduction to Digital Currencies for Professionals” can be found on the the firm’s website at www.libratax.com. Jake Benson, the founder and CEO of LibraTax, is a member of the DCC.
Tax Treatment of Digital Currency
Digital currencies are subject to tax treatment in the United States that is similar to other asset classes under similar circumstances. In the spring of 2014, the IRS released guidance to the public that explicitly classified digital currencies as property, rather than “foreign currency. ”
“Property” is a fairly non-specific term under the tax code. Since digital currencies are versatile, tax treatment varies based on the context of their acquisition and use. The normal property classification rules under Section 1221 apply to digital currencies. Thus, digital currencies as property can be classified into existing categories of assets under the Internal Revenue Code, such as capital and non-capital assets.
The biggest challenge facing users of digital currencies is maintaining records that will be useful at tax time. In order to be usable, records must list every acquisition and disposal during the year, the date when each transaction occurred, and the exchange rate in effect at that time.
Digital currency miners realize ordinary income when the mining activity results in the receipt of digital currency. Income is not deferred until mining receipts are converted or sold, but must be declared in the tax year actually mined. The market value of the digital currency received on the date of receipt is typically used to calculate income.
If a taxpayer participates in a mining pool, then he or she may be required to use the date that the digital currency was mined by the pool, rather than the date received by the miner (there may be a time lag between these two events), depending on the tax structure of the pool and its operating rules.
Miners may be considered either hobbyists or business owners depending on the scope of their activities. Due to the expense associated with operating a “mining rig”, treating mining activities as a business normally generates more favorable tax treatment. Material participation and active participation rules apply, as do hobby loss rules.
If mined bitcoins are not immediately disposed of, then their taxability will be broken into two parts:
• Ordinary income is recognized on receipt, establish tax basis at their value on the date received.
• Short term or long term capital gain or loss is recognized at the time of conversion or disposal.
Digital currencies are usually considered capital assets in the hands of individuals, subject to most of the same rules and tax treatment as more common capital assets, such as securities. Most rules applicable to securities trading are also thought to be applicable to digital currency trading. Digital currency exchanges are not currently required to report basis or trade information to US taxpayers or to the IRS on IRS Form 1099-B.
At present, the methods allowable for securities trades are believed by many practitioners to also be allowable for digital currency trades. These include first in first out (FIFO), last in first out (LIFO), and specific lot identification. Average cost may also be allowable. The IRS has issued no guidance on this subject as yet. There are technical reasons why this question may remain unsettled for some time to come. For example, digital currencies usually are not traded in discrete lots (especially with regard to purchases and sales). Additionally, the protocol that governs exchange in many digital currency systems does not allow users to manually select specific lots. This suggests that any method selected by a taxpayer will be artificial by definition.
A “wash sale” occurs when a taxpayer sells a security at a loss and reacquires the same (or a substantially similar) security within thirty days. The rule prohibits recognition of the loss on the sale. Since digital currencies are not, by definition, securities, IRS wash sale rules do not apply to digital currency transactions.
Like-Kind Exchange Treatment
Like-kind exchange treatment allows the gain on disposal of a capital asset to be deferred if the proceeds are reinvested into another asset of like-kind within a certain period of time. Taxpayers may be able to take advantage of like-kind exchange treatment to defer gains when trading between different digital currencies of like-kind. Like-kind exchange treatment greatly simplifies tax reporting by limiting the number and type of transaction that are required to be declared at tax time.
This is another topic on which the IRS has not yet provided definitive guidance. Specifically, the IRS has not declared whether digital currencies in general are like-kind to one another, or if not, then what attributes must be shared in order to qualify for this treatment. Certain digital currencies are more alike than others in terms of the protocols and underlying software code (example: bitcoin and litecoin), so it is not inconceivable that some may be like-kind, while others would not.
The ability to seamlessly employ digital currencies to pay for everyday purchases (the proverbial “cup of coffee”) is the holy grail of the digital currency movement. Unfortunately, current IRS rules make daily transaction tracking a difficult and time consuming affair.
When a digital currency is used to make a purchase, the event is treated the same as a disposal due to sale, triggering recognition of capital gain or loss in most circumstances. Transaction tracking tools such as LibraTax provide some relief, but users must manually enter most disposals into their own transaction records.
Businesses that accept digital currencies in settlement of sales recognize ordinary income equal to the US dollar value of the sale. Receipts denominated in digital currencies do not abrogate local sales, use or excise tax rules or otherwise relieve merchants of the responsibility to accurately record and report revenue in any way.
There are few explicit restrictions on acceptance of digital currencies in payment. However, a small number of jurisdictions are known to prohibit digital currency payments for highly regulated goods, such as alcohol.
If digital currencies are not immediately disposed of, then their taxability is broken into two parts- ordinary income on receipt to establish basis and capital gain or loss at disposal. This means that businesses using digital currencies to pay vendors or employee salaries face additional record keeping requirements beyond merely booking the expenses.
Gifts are a major part of the digital currency community. It is not uncommon to see a digital “tip jar” at the bottom of a blog post or other piece of original content or to find enthusiasts seeking gifts of digital currencies to fund projects that are of interest to the general community. Digital currencies make it possible to send payments as small as a fraction of a cent without the expense of credit card interchange fees.
Gifts of digital currencies are subject to IRS gift tax rules in the United States in the same manner as other forms of personal property. Gifts of digital currencies are not exempt from reporting and count toward annual and lifetime exempt gift limits for US taxpayers.
Charitable donations of digital currencies are subject to IRS rules governing donated non-cash property, including deductibility limits and value substantiation requirements. Donors should carefully maintain records of the date and amount of all charitable donations and be sure to obtain a receipt from the recipient of the donation.
Use caution: donations to non-qualifying entities may actually be considered non-deductible gifts under IRS tax rules.
Non-Resident Alien Taxation
Almost all capital gains belonging to a Non-Resident Alien, including digital currency gains, are not taxable. They need not be declared and no return is required.
Unanswered Tax Questions
Practitioners are likely to encounter situations where the law is not clear as to how a bitcoin transaction or investment should be treated. Notice 2014-21 includes the general
caveat: General tax principles applicable to property transactions apply to transactions using virtual currency.” Also, with Notice 2014-21, the IRS sought comments from the public and additional guidance may be forthcoming. Be sure to see if your state has issued any guidance on income, sales or other types of taxes and virtual currencies.