In March of 2014, the IRS made an important decision regarding Bitcoins (including all virtual currencies) and taxes. IRS Notice 2014-21 declared that Bitcoins do not have legal tender status and therefore should be treated as property instead of currency.
For those trading in Bitcoins only as investments, this ruling has fairly straightforward effects. Bitcoin gains and losses are dealt with in the same fashion as with stock. However, consumer uses for Bitcoins have increased since sites like Overstock.com have begun accepting them, and tax implications in those cases are somewhere between intriguing and annoying.
If you make regular purchases with Bitcoins, you may have a tax accounting nightmare on your hands. It is as if you paid your regular grocery store bills with volatile shares of stock. Every trip for milk and eggs requires calculating a capital gain (or loss) on the exchange, which means you must know the value of the Bitcoins in dollars at the time you purchased them and the value of the Bitcoins at the time you spent them (in essence, the fair market value of the milk, eggs, etc. that you received).
If you purchased Bitcoins multiple times, you have the further burden of clear records regarding which Bitcoins (or parts of a Bitcoin, since they are divisible) you spent and which remain in your account, since they have different initial values. It is best to seek professional tax accounting advice in that case.
Had Bitcoin been classified as a currency, as many believe it should be (including the Tax Foundation), this would be a more straightforward issue of currency exchange rates – like paying your grocery bills with Euros or yen.
From the business side, typical reporting rules apply. For example, if you are a Bitcoin “miner”, your earnings are considered self-employment income with the requisite self-employment taxes. Employees who are paid in Bitcoins must have the fair market value in dollars on the payment date reflected in their W-2 forms.
If you are an independent contractor paid in Bitcoins, you should receive a 1099 form reflecting the proper Bitcoin value. The employer is obligated to send the 1099 to you, and you are obligated to pay self-employment tax. Good luck estimating your quarterly payments in that case....
What are you, the average taxpaying Bitcoin user, to do? As with all Americans, fill out your taxes to the best of your ability and seek professional advice for more complicated transactions. Track your Bitcoin transactions, calculate all capital gains/losses, and report them similarly to stock transactions.
Bitcoins were poor investments in 2014, dropping from $748 at the beginning of the year to $317 by December 31st. Because of this drop in value, the odds are pretty good that you will not owe any taxes this year…and if you dealt with Bitcoins in any significant way, you could have a capital loss that actually reduces your taxes.
The bottom line for taxpayers is to keep meticulous records on your use of Bitcoins – when you received them, when you spent them, what you spent them on, and their market value at the time. You can retrieve and export most records with minimal headache through Blockchain and other web alternatives.
Taxpayers with few Bitcoin transactions may be tempted to blow the whole thing off. We advise against that. Granted, for most people the chance of detection is small, but why mess with the IRS at all? Seek the advice of tax professionals if you need to, but ignore the tax ramifications of Bitcoin at your own peril.