The IRS has announced that it will treat Bitcoin and other virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, as property for tax purposes and not foreign currency. As a result, the general principals that apply to property transactions also apply to virtual currency. Thus, taxpayers could claim capital gains and losses on Bitcoin that the taxpayer used to acquire other property or pay for services.
In Notice 2014-21 (linked below), the IRS addresses 16 “frequently asked questions” on the taxation of virtual currency. For example, a taxpayer who receives virtual currency as payment for goods or services must include in his gross income the fair market value of the virtual currency, measured in U.S. dollars as of the date the virtual currency was received. A taxpayer that uses Bitcoin or other virtual currency to purchase property or to pay for services can also recognize taxable gain or loss on the transaction. If, for example, the fair market value of the property received by a taxpayer in exchange for virtual currency exceeds the taxpayer’s tax basis in the virtual currency, the taxpayer will have a capital gain, as long as the virtual currency was a capital asset in the hands of the taxpayer. If the fair market value of the property received in exchange for the virtual currency is less than his basis in such virtual currency, the taxpayer will have a loss; however, the deductibility of capital losses in excess of capital gains is limited.
The notice makes it clear that virtual currency is not treated as foreign currency that could generate foreign currency ordinary gain or loss under Section 988 of the Internal Revenue Code. According to the notice, virtual currency used to pay for services of an employee constitutes wages for employment tax purposes and thus the fair market value of such virtual currency is subject to income tax withholding and FICA and FUTA taxes, and must be reported on Form W-2. Virtual currency used to pay independent contractors must be reported on Form 1099-MISC and payments of virtual currency are also subject to backup reporting. A taxpayer who “mines” virtual currency is subject to tax on the amount received.
The notice takes effect immediately and covers past and future transactions and tax returns. However, in the notice, the IRS suggested that it might offer relief from penalties to taxpayers who engaged in virtual currency transactions before March 25, 2014, and can show “reasonable cause” for any underpayments of tax.
See: Notice 2014-21.