The rise of bitcoin and other cryptocurrencies has brought about a whole new set of fascinating taxation issues. Currently, the market value of bitcoin is in the low $8,000 range – as of today it is approximately $8,270 – and its value has fluctuated widely over the past several years. At its peak, bitcoin boasted a market price of roughly $19,000, which is quite an impressive improvement when you consider its humble beginnings. Though a large percentage of Americans are still unfamiliar with bitcoin, news about this intriguing currency is spreading fast and it seems likely that the word will continue to travel at a healthy pace. Even if bitcoin ultimately fails or is outlawed, both outcomes are distinct possibilities, there’s reason to think that one of its competitors may simply rise to fill the void. Cryptocurrencies are here to stay, even if as minor players in the financial world, but how exactly bitcoin taxation will be treated is still largely unanswered.
Fortunately, the IRS and SEC have gradually become involved and are starting pay closer attention to bitcoin and other cryptocurrencies. The IRS has even released a document, Notice 2014-21, in which it stated that bitcoin will be treated as “investment property” and will trigger both capital gains and ordinary income depending on precisely how it is held and used by taxpayers. Though this document has helped to clarify many of the issues surrounding bitcoin, the full picture is still emerging, and quite a bit of time will pass before everything is settled. In this article, we will discuss the basic mechanics of bitcoin and then cover in greater detail some of the issues related to bitcoin and taxation.
Bitcoin is a “digital currency” (or “virtual currency”) which means that it does not have possess physical attributes. To possess bitcoin means having the ability to transfer bitcoin to another person or entity. Bitcoin holders store their currency in a “digital wallet” which has its own security key to deter or avoid theft. On its surface, the mechanics of bitcoin seem fairly straightforward: to use their currency, bitcoin users simply transfer a fixed quantity of bitcoins to a third party and then receive the goods or services which they bargained for to complete the transaction. Underneath the surface, however, the mechanics of bitcoin get a bit more complicated.
Since bitcoin is its own standalone currency, and is entirely digital, it requires a sophisticated system to make it functional. When a bitcoin user transfers currency from his or her digital wallet, this transaction has to be “verified” in order to ensure that the user actually possesses the bitcoins being sent. Transactions are verified when other people outside of the transaction use computer power to solve incredibly complicated cryptographic puzzles. Once a transaction is verified in this manner, the bitcoin transaction is then logged away into a public ledger referred to as a “blockchain.” And when a transaction is verified, this act itself results in the creation of bitcoin because whoever solves the puzzle receives additional bitcoin as a reward. Hence, bitcoin is designed to be totally self-sustaining and capable of perpetuating itself without any government involvement or other kind of supervisory authority.
Issues with Bitcoin Taxation
IRS Notice 2014-21 did a lot to clarify how bitcoin will be treated for federal income tax purposes. The IRS now classifies bitcoin as investment property, and so bitcoin taxation will be handled much like that of other investment properties (e.g., stocks, bonds, notes, etc.). However, whether bitcoin is taxed at the capital gains rate or ordinary income rate depends on the nature of how it is acquired and held. For instance, if a person “mines” for bitcoin, which is the term used to describe the process of verifying bitcoin transactions for the purpose of generating more bitcoins, then the bitcoin would be taxed as ordinary income when it is received. Further, if an individual were to mine bitcoin as a business or trade, then the receipt of bitcoin would trigger self-employment income tax.
If, however, a person acquires bitcoin and then holds it as an investment, and that person’s intent to hold it can be firmly established with reference to all the facts and circumstances, then the bitcoin will be treated as a capital asset and taxed at the applicable capital gains rate. Things can get tricky when bitcoin is mined or received as wages because in either case its fair market would need to be determined for tax purposes. Bitcoin’s market value tends to be quite unstable, and so recipients would need to determine precisely the convertible value of bitcoin in U.S. dollars prior to paying tax. If someone were to mine or receive bitcoin as wages and then subsequently held the bitcoin for investment, then the bitcoin would first be taxed as ordinary income and then later at the capital gains rate when eventually cashed out.
There’s other issues as well, such as whether bitcoins “exchanged” for other cryptocurrencies under IRC Section 1031 will hold up as legitimate transactions. Following the Tax Cuts & Jobs Act which took effect in January, 2018, only real estate exchanges are permissible under Section 1031, but bitcoins exchanged earlier may still pass inspection as personal property exchanges. Whether these transactions hold up after IRS scrutiny will depend on whether the IRS treats bitcoin similar to stocks, bonds or other properties which are specifically excluded by the section.
If you’re presently in possession of bitcoin or think you may come to acquire some in the future, it’s best to consult with a qualified tax attorney so you can be certain you’re doing everything correctly. Taxation issues can be difficult enough to deal with when they involve matters which are familiar to most of us, so it follows that they can be downright maddening if it involve something as unusual as bitcoin taxation. Luckily, the tax attorneys at Mackay, Caswell & Callahan, P.C. stay up-to-date with cutting edge issues such as these and would be more than happy to assist you with your bitcoin taxation query. Contact us today to speak to one of our highly experienced New York tax attorneys!