If you've been hoping cryptocurrencies such as Bitcoin would permit seamless, hassle-free transactions, think again. The utopian vision of an open financial system is probably not to be, at least not anytime soon. One need only look at the nightmare created by U.S. tax laws.
The Internal Revenue Service (IRS), with a notable knack for making things complicated, rejects the notion that cryptocurrencies are a form of legal tender, instead characterizing them as property. That's where the complexity arises. In a perfect world, perhaps, using bitcoins or other digital tokens would be as simple as traditional money, but that's not the case today. The IRS has explained its basic rules on cryptocurrency in Notice 2014-21.
Read on for more information about how cryptocurrency taxes apply when crypto currencies like Bitcoin are used to purchase goods and pay employees and when they're traded for other securities.
Cryptocurrency Taxes on Consumer Purchases
When you use a credit or debit card to buy a sandwich, you don't pay any tax on the transaction except maybe sales tax, but cryptocurrency is different. While it may seem bizarre, you might owe capital gains tax as a result of your lunch purchase.
Let's say you buy a $100 meal using virtual coins that you paid $50 for and have happily watched double in value. Lucky for you, the coins now cover the full cost of the food. On the downside, the IRS may say you've realized a $50 gain from this transaction and owe capital gains taxes on that amount. The reason is because the IRS treats your virtual currency not as money but property (think rare stamps or artwork). You gained $50 from your fast-appreciating investment and now must pay the tax collector.
In addition, you're required to keep a record of the transaction for tax purposes.
Cryptocurrency Taxes in Other Situations
But that's just one type of cryptocurrency transaction. In other cases, the tax consequences will be different based on rules set forth by the IRS. Here are a few examples of how cryptocurrency taxes are levied in other situations.
- When received as wages, virtual coins are taxed as earned income. Independent contractors must pay self-employment taxes as well.
- When received as revenue, virtual coins are taxed as business income.
- When exchanged, traded, or converted, virtual coins generate capital gains or losses.
- When brought into existence through "mining" (solving complex computational problems to mint new coins), virtual coins are the miner's earned income.
- When sold or distributed in "initial coin offerings," a separate set of tax questions arises.
In each instance, the IRS will deem the virtual coins to be worth their fair market value in dollars at the time of payment or receipt.
While it may be tempting to pretend that these tax rules don't exist or can safely be ignored, that can be a risky strategy with the IRS. The same goes for state tax rules.
Other sorts of regulations exist too. For instance, the Securities and Exchange Commission has begun to regulate initial offerings of new cryptocurrencies as if they were initial public offerings of stock. Some states have also adopted mandates in their laws.
Maybe someday crypto such as Bitcoin and Ethereum will bring about a world of frictionless buying and selling. For now, though, users of virtual currencies that can be converted into dollars still have to deal with the realities of the current financial system.
Have Questions About Bitcoin Taxes? Speak with a Lawyer
If you're in a tax bind over a virtual coin transaction or any other situation where crytpocurrency is being used, a tax attorney can help you through the process. Consider reaching out to a qualified tax lawyer near you as you navigate this complex and uncertain new legal terrain.