We have had more than a few clients this past year ask about Bitcoin and trading in Bitcoins from an income tax perspective. There has been a lot of urban legends out there that claim, since the IRS has not given any formal guidance, that income taxes don't apply. Like most urban legends, that is simply wrong and making that assumption can land you in some real tax trouble.

When we delivered that news it was sometimes not what our client, or prospective client, wanted to hear. We've had to remind everyone that the primary premise of the U.S. Tax Code, Section 61, is pretty simple. It says that "gross income means all income from whatever source derived." So, unless there is a specific exclusion from taxability for the income source, you're on the hook for taxes.

There are different types of tax that can be applied to income. For example, is your gain in Bitcoin going to be ordinary income (highest tax rates) or capital gain income (lower tax rates)? And what about self-employment taxes? With today's IRS' posting of a notice, IR-2014-36 on March. 25, 2014 the jury is now in.

The official IRS Notice 2014-21 says that Bitcoin and other virtual currencies are considered property, not currency.

This means that many virtual currency owners will regard their holdings as an investment and will be able to take advantage of the capital gains tax, which allows you to pay a lower percentage on holdings sold after a year (long term gains) and also deduct up to $3,000 in losses per year (and carry forward to future years losses beyond the $3,000 limit). But those who use Bitcoin and other virtual currencies as an actual medium of exchange will have to shoulder additional paperwork.

By the way, virtual currency miners will report their earnings as taxable income, and will be subject to payroll taxes or self-employment taxes if they mine as part of a business.

The IRS notice stresses a point — widely overlooked by many — that using Bitcoin to purchase an item or service triggers capital gain or loss recognition reflecting appreciation or depreciation of Bitcoin. Compare the market price on the date Bitcoin is used to make a purchase vs. the market price on the date you acquired that Bitcoin, and the difference is your capital gain or loss on property.

Most likely not many companies have filed Form 1099s to report these types of transactions and even more taxpayers will have to dig around to figure their cost basis and sales proceeds on each purchase where they used Bitcoin as a digital currency. Now that is a lot of paperwork with which to contend.

Having to report a capital gain or loss on each purchase using Bitcoin will likely be a significant block in the road toward Bitcoin reaching its goal to be a widely used virtual currency. Who wants to spend all your spare time figuring out their capital gain or loss for a simple $4 cup of coffee?

Confused? Frustrated? Don't be concerned. You can give us a call and we will be happy to help you sort through your Bitcoin or other virtual currency tax accounting. We have kept abreast of the tax issues since day one and the expertise to help you make sure you do not run afoul of the tax reporting or pay more than you legally must.

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