What You Need to Know About Bitcoin & How It Is Taxed

What is Bitcoin?

Bitcoin is a form of electronic digital currency. Bitcoins can be used to buy goods electronically from thousands of vendors. Others are looking at Bitcoin as a potential investment, and are holding them as an investment to benefit from future appreciation. Bitcoin has created a new asset class, and it is continuing to become more mainstream every day.

What is different about Bitcoin is that it is decentralized. This means that no single institution controls the Bitcoin network. Many believe that Bitcoin is anonymous. This is not true because every Bitcoin is recorded on something called the blockchain. The blockchain is a public distributed ledger that is part of a very large database. Thousands of computers worldwide maintain a full copy of the blockchain. Every time a Bitcoin is created, transferred, bought, sold or spent, the transaction is recorded on the blockchain. Every transaction can be traced to the originating address and the destination address. Those addresses are mostly virtual wallets of some sort, as long as the person or entity that setup the virtual wallet used some real identifying information, it is very easy for anyone to track down that person or entity. Bitcoin uses digital signatures to help make sure the transaction is secure; however, Bitcoin cannot verify that the signature was provided by a legitimate user or if it was from another party. If you are concerned with anonymity, there are websites that help local buyers and sellers of Bitcoin meet to handle person to person transactions.

How is Bitcoin Taxed?

The Internal Revenue Service (IRS) has taken the position that Bitcoin is considered property. In Notice 2014-21, 2014-16 I.R.B. 938, the IRS provided guidance on how existing general tax principles apply to virtual currency transactions. The Notice clarifies for taxpayers that if the fair market value of property received in exchange for virtual currency, such as Bitcoin, exceeds the adjusted basis of virtual currency, the taxpayer has a taxable capital gain. For example, a taxpayer using Bitcoin with an adjusted basis of $70 to buy property worth $100 has realized a gain of $30. On the other hand, the taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of Bitcoin.

This treatment as property and not currency is currently being challenged in the courts by many taxpayers and is an unsettled issue. The IRS is challenging taxpayers who are not paying taxes on the gains they are receiving from selling Bitcoins or buying property with them. This is important to the IRS because many people are making significant gains that are going untaxed. These people may or may not know that the money they made is subject to taxation.

Due to the IRS's belief that many taxpayers are not reporting these transactions (citing that only 802 Coinbase users filed a tax return relating to Bitcoin), the IRS has issued a "John Doe" summons, which is an order that does not specifically identify a single person, but identifies a group or class by their activities. A judge granted this motion and stated that there is a reasonable belief these individuals using Bitcoin have failed to comply with Internal Revenue laws. The IRS revealed that the point of the summons was to produce information revealing the identity of certain unknown taxpayers. The summons could affect almost 3 million Americans. The IRS has issued a very broad summons, asking for all of the financial transactions that happened from 2013 to 2015.

Coinbase was identified as the sole recipient of the summons for the IRS. Coinbase is the largest digital currency exchange in the United States. The IRS does not actually have a true factual basis for asserting their claim. Specifically, for the years the summons are asking for (2013, 2014 and 2015), more people lost money selling Bitcoin than making it. There was a huge crash in late 2013 and this was when Bitcoin traded at over $1200 per coin. The crash happened because one of the world's largest exchanges was hacked and millions of dollars in Bitcoin were stolen. The price of Bitcoin dropped to about $200 per coin shortly after and did not fully recover to the $1,200 per coin until early 2017. This means that everyone who bought Bitcoin in 2013 sold it for less in the following years until it reached that $1,200 mark again. One Bitcoin customer responded to the summons by filing a motion to set aside the ruling. Because he identified himself as a user, the IRS stated that he is no longer subject to the summons.

What Should You do if You are a Bitcoin User?

There are many ways to purchase Bitcoin. Coinbase, GDAX, Gemini, and CoinX are a few of the U.S. based exchanges available. U.S. based exchanges that want to operate above board have adopted strict rules that require their customers to provide a lot of information when they purchase Bitcoin. You also have the option to use a foreign exchange, too.

In order to sell your Bitcoin you have many options: you can sell it directly to another person in a trade, you can sell it through an online exchange, you can sell it and obtain discounted goods in a peer-to-peer trading market place, or you can sell it directly to a merchant that chooses to accept Bitcoin as a currency. Many companies like Overstock, Microsoft, Dell, Whole Foods, and Dish Network have chosen to accept Bitcoin directly as currency. Also, multiple countries are looking into legalizing Bitcoin as a form of payment in their country. Japan is one of the most current countries to consider this. In fact, in April 2017, Japan began to accept Bitcoin as legal currency. As a result, the value of Bitcoin has increased dramatically.

When you sell your Bitcoin you choose how many you want to sell and what price you sell it for. This is how you make money with Bitcoin when using it as an investment tool. The goal is to sell it for more than you bought it for. The price of Bitcoin is constantly changing, which gives buyers an opportunity to make money. Once the Bitcoin is sold, the currency is deposited into your account.

If you need assistance with reporting income from the sale of Bitcoin or other virtual currency, contact Glen E. Frost at Frost & Associates today at 410-497-5947.