With virtual currencies like Bitcoin becoming more mainstream in recent years, we often get asked if revenue from the sale or exchange of these digital dollars is taxable. The simple answer is, YES – income (or profit) from virtual currency transactions is reportable on your income tax return. However, because this is still a relatively new phenomenon, there are a few things you should be aware of to make sure you don’t get caught with a huge tax bill!

Virtual currency, as generally defined, is a digital representation of value that functions in the same manner as a country’s traditional currency. Bitcoin is one example of a convertible virtual currency which can be digitally traded between users and purchased for, or exchanged into, U.S. dollars, Euros and other real or virtual currencies. There are currently more than 1,500 known virtual currencies. Because transactions in virtual currencies can be difficult to trace and have an inherently anonymous aspect, some taxpayers could be tempted to hide taxable income from the IRS.

This is NOT a good idea! While their systems may be less than state-of-the-art, the IRS has computers with access to all the Big Brother data collected by various arms of the U.S. government. As recent events have shown, you may not be as anonymous as you think!

Virtual currency transactions are taxable by law just like transactions on any other property. The IRS has issued guidance in IRS Notice 2014-21 for use by taxpayers and  return preparers that addresses transactions in virtual currency, also known as digital currency.

Of course, taxpayers who don’t properly report the income tax consequences of virtual currency transactions could be audited and, when appropriate, be liable for penalties and interest. In extreme situations, taxpayers could even be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions.

So, how are we supposed to handle transactions in virtual currency?

IRS Notice 2014-21 provides that virtual currency is treated as property for U.S. federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency. Among other things, this means that:

• If you’re just speculating or trading in virtual currency, each sale of the currency is a potentially taxable event. You have to compare what the lot (or batch) of currency cost you to what you got for it when it sold. The difference is taxable as a profit or loss.
• A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
• Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply.  Normally, payers must issue Form 1099-MISC.
• Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes.
• Certain third parties who settle payments made in virtual currency on behalf of merchants that accept virtual currency from their customers are required to report payments to those merchants on Form 1099-K, Payment Card and Third Party Network Transactions.

The Cryptocurrency Tax Fairness Act introduced by Reps. Jared Polis, D-Colo., and David Schweikert, R-Ariz., in 2017 would allow taxpayers to exclude cryptocurrency transaction gains of $600 or less from their gross income. However, that legislation hasn’t moved beyond the House Ways and Means Committee.

As you can see, virtual currencies are a tricky thing – especially when it comes to taxes. It’s important to know what you’re dealing with and avoid getting tripped up by common misconceptions or inaccurate information.

Have a question? Contact Dannylle Milford.

Your comments are always welcome!