Recently, the IRS issued Notice 2014-21, its much anticipated guidance on the tax treatment of Bitcoin and other virtual currencies. The notice provides that virtual currency is treated as property, rather than currency, for federal tax purposes. This has significant implications for those who invest in — or conduct transactions using — all virtual currencies.

What is Bitcoin?

Bitcoin is a digital currency system created and maintained on a peer-to-peer payment network. Bitcoins can be purchased through online exchanges or acquired in transactions with other users. Users store Bitcoins in “digital wallets” and conduct transactions using digital signatures and other security measures. All transactions are recorded on and validated by a “public ledger” shared across the network.

The Bitcoin network relies on a process called “mining.” In exchange for a fee (usually paid in Bitcoins), network participants (“miners”) supply computing power to validate transactions and maintain the public ledger.

Bitcoin isn’t controlled by any government, nor does it require the use of banks or other intermediaries, so users retain complete control over their funds and transactions are faster and cheaper to execute. Transactions can be performed without providing any personal information, offering anonymity and protection against identity theft. And Bitcoin enables merchants to avoid credit card fees and regulations.

However, these funds aren’t FDIC-insured, and Bitcoin wallets stored in the cloud are vulnerable to hackers. Also, because the total value of Bitcoins in circulation is still relatively low, prices are volatile — although this may change as Bitcoin becomes more widely accepted.

How are Bitcoin Transactions Taxed?

The IRS’ classification of Bitcoins as property means that:

• Wages paid in Bitcoins are taxable to employees, reportable by employers, and subject to federal withholding and payroll taxes.

• Bitcoin payments to independent contractors are reportable on Form 1099 (if the $600-per-year threshold is met) and are subject to income and selfemployment taxes.

• Mining fees are included in gross income and, if mining constitutes a trade or business, net earnings may be subject to self-employment taxes.

The fair market value of Bitcoins (typically, as quoted on one of the online exchanges as of the transaction date) determines the amount included in wages or income. Unlike investors in foreign currency, investors who dispose of Bitcoins typically recognize capital gains or losses. This is bad news for those who lose money on Bitcoin investments and hope to treat them as ordinary “exchange losses.”

Notice 2014-21 also places a burden on those who use Bitcoins to purchase goods or services. If the value of the Bitcoins has increased since they were acquired, a purchase may trigger capital gains taxes. Users must track their basis in Bitcoins and calculate the gain (or loss) each time they make a purchase.

Suppose, for example, that you buy 50 Bitcoins for $500 each, giving you a $25,000 tax basis. Later, when Bitcoins are trading at $600, you use them to buy a $30,000 car. You have a taxable gain of $5,000.

How are Bitcoin Transactions Reported?

Practically speaking, information reporting may be a bigger obstacle to Bitcoin use than taxes. Suppose you engage a website designer in India whom you pay in Bitcoins. Under Notice 2014-21, you must obtain the contractor’s taxpayer ID and file Form 1099 or, alternatively, withhold 28% of the payment.

However, Bitcoin is designed to allow anonymous transactions. So it may be difficult to determine whom you’re paying — or whether you’ve met the $600 threshold.

Stay Tuned

If you use or invest in Bitcoin or other virtual currencies, keep an eye on Congress, the IRS, and other government agencies as additional laws or regulations governing virtual currency are expected in the months and years ahead.

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