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

What is Bitcoin?

Bitcoin is a form of electronic currency. Bitcoins can be used to buy goods electronically. What is different about Bitcoin is that it is decentralized. This means that no single institution controls the Bitcoin network. The network is also anonymous which allows anyone to make transactions without being detected.

How is Bitcoin Taxed?

The Internal Revenue Service (IRS) has figured out that many people are not paying taxes on the gains they are receiving from selling their Bitcoins. This is important to the IRS because many people are making significant gains that are untaxed. These taxpayers may or may not know that the money they made is subject to taxation, just like regular income.

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 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.

Due to the concern that significant gains are going untaxed, 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 explained 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 problem with this general type of summons is that many of the identities that will be revealed belong to people who have already reported the gains on their tax returns and should not be subject to this summons because they followed the law. The IRS has issued a very broad summons, asking for all of the financial transactions that happened from 2013 to 2015. One Bitcoin customer responded 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. The IRS is trying to figure out who needs to pay taxes on their capital gains and who has already done so; in the process, they are invading millions of people's privacy.

What Should You do if You are a Bitcoin User?

To purchase a Bitcoin, you must sign up for a website called Coinbase. Once on this website, you can connect your bank account and then you can start buying Bitcoin. In order to sell your Bitcoin, you have three options: you can sell it directly to another person in a trade, you can sell it through an online exchange, or you can sell it and obtain discounted goods in a peer-to-peer trading marketplace. When selling your Bitcoin, you may choose how many you want to sell and what price you sell it for. This is how you may make money with Bitcoin. The goal is to sell it for more than you bought it for. The price of Bitcoins is constantly changing, which gives buyers an opportunity to make money. Once the Bitcoin is sold, the currency is deposited into your account.

Virtual currency, like Bitcoin, is treated as property according to the IRS; this means that wages paid to employees are taxable to the employee and payments made to independent contractors and other services provided are also taxable. Gains or losses from the sale of Bitcoins are potentially taxable depending on whether the currency is considered a capital asset to the taxpayer. A capital asset is defined as an asset that has an expected life of more than 1 year and is not bought and sold in the usual course of business. This could mean a large sum of Bitcoin that the seller has waited to sell at a very high price. Due to the virtual currency being treated as property, this also means that a payment made using virtual currency is subject to information reporting in the same way that property is subject to information reporting.

One should seek help from a tax law firm or tax advisor if he or she thinks their sale of Bitcoin could possibly be considered a capital gain.