There’s been a steep rise in the use and price of cryptocurrency or virtual currency (such as Bitcoin) recently, and you and your clients may have questions about the tax implications. Bitcoin and other cryptocurrencies have been around for almost a decade and can be traded digitally on the internet, used to buy goods and services and exchanged into U.S. dollars.
Virtual currency can be a source of investment and speculation. Using digital currency for purchases of goods and services (where accepted) carries the following benefits: easier and safer than paying with cash; cheaper than using credit cards; conducive for use in the global economy; and it is not subject to inflation.
General principles established by IRS
Legal tender is used and accepted as a medium of exchange and is used as payment for goods and services in the country of issuance, but not typically outside the jurisdiction. Depending on the environment, virtual currency can be treated like real currency (paper and coin money in the U.S.) and accepted as a means of payment. However, virtual currency does not have legal tender status in any jurisdiction.
Virtual currency is typically listed on an exchange with the price established by market supply and demand conditions. The fair market value of the virtual currency on any given date is determined by converting it into U.S. dollars at the exchange rate.
For federal tax purposes, virtual currency is treated as property and not currency. The fair market value of the virtual currency on the date of receipt determines the taxpayer’s basis.
Wages paid to employees in virtual currency instead of in U.S. dollars are taxable to the employee and must be reported on Form W-2. The employee is taxed at the fair market value of the digital currency.
Payments made to independent contractors for services provided using virtual currency are subject to income tax and self-employment tax and reported on Form 1099. The fair market value of the virtual currency establishes the taxable amount.
If you receive virtual currency as payment for goods and services, the fair market value of the virtual currency is included in taxable income.
The character of the gain or loss from the sale or exchange of virtual currency will depend on whether the digital currency is a capital asset (like stocks and bonds) or is held as property for resale to customers (inventory item).
Virtual currency can be acquired through a mining process by using complex, encrypted mathematical equations. If you mine virtual currency, the fair market value of digital currency at the date of receipt is included in gross income.
Like-kind exchange treatment goes away
Some tax law specialists and virtual currency traders have treated the exchange of one virtual currency for another as a like-kind exchange of property. This treatment defers any gain realized on the transaction until you ultimately exit the cryptocurrency market altogether.
However, under the recently passed tax reform law and effective beginning in tax year 2018, like-kind exchange treatment can no longer be claimed for exchanges of personal property but can only be claimed for exchanges of real property. Thus, investors are no longer able to defer taxes when they exchange one virtual currency for another at a gain on the price appreciation. Instead, the investor must recognize a capital gain on the appreciation once the transaction is completed.