How Will the IRS Tax Bitcoin?

[kcjenkins]

Despite a recent plunge, bitcoin has had a banner year. Now comes the hard part—figuring out the taxes on it.

For the uninitiated, bitcoin is the most prominent of several "virtual currencies"—money that exists only online and isn't backed by any government. Released in 2009 by an unknown person or group going by the name Satoshi Nakamoto, bitcoin is maintained by a decentralized network of computers, called "miners," that process and verify transactions. As of Friday afternoon, the value of all bitcoins in circulation was nearly $8 billion, according to CoinDesk.

This year the price of a bitcoin has risen from about $13.50 to about $650 on some exchanges, down from a November high of about $1,200 just before concerns arose that China will crack down on the virtual currency.

Experts say, however, that there's no agreement on a host of fundamental questions for U.S. taxpayers holding or using virtual currencies. "People who invested in bitcoin or used it to buy goods or services this year have gains or losses, but no rules for reporting them," says Omri Marian, a professor of law at the University of Florida in Gainesville. "What should they do in April?"

Among the pressing issues: When should bitcoin be considered a commodity, a currency or a capital asset for tax purposes? Are bitcoin transactions similar to barter? Is bitcoin subject to the same stringent tax rules as secret offshore accounts? And how will U.S. officials keep bitcoin, which is even more anonymous than cash, from being used to promote tax evasion or money laundering?

So far, the Internal Revenue Service hasn't ruled on or addressed such issues directly. An agency spokesman released the following statement: "The IRS continues to study virtual currencies and intends to provide some guidance on the tax consequences" of transactions involving them. The agency is also "aware of the potential tax compliance risks posed by virtual currencies," he added.

Meanwhile, bitcoin investors and users should be aware of some thorny basic issues. If bitcoin is a capital asset like a stock, says David Shapiro, a principal at PricewaterhouseCoopers in Washington, then long-term capital gains and losses—those on assets held for more than a year—would qualify for a top federal rate of about 24%. But losses above $3,000 could only be deducted against other capital gains.

If, on the other hand, bitcoin counts as a currency (like euros or yen), then gains will be taxed at federal rates on ordinary income up to 43.4%, Mr. Shapiro says, and losses will be fully deductible against ordinary income like wages.

In its preliminary filing, the Winklevoss Bitcoin Trust—a public fund registered by brothers Cameron and Tyler Winklevoss, of Facebook fame—said it intends to treat bitcoin as a capital asset instead of a currency, unless the IRS rules otherwise.

Clearly, someone could have a taxable gain or loss in bitcoin when it is sold or given away. But there could also be a taxable gain or loss when bitcoin is used simply to purchase goods or services, says Mindi Lowy, a tax director at PricewaterhouseCoopers in New York. "The fact that using bitcoin to buy something could trigger taxes will come as a surprise to typical consumers," she says. Most people, after all, don't think of spending money as an act that could generate taxable gains or losses.

Taxpayers may also have difficulty tracking a bitcoin's "cost basis," which is the price used as the starting point for measuring taxable gain or loss, says Ms. Lowy. Unlike with assets such as stock or mutual funds, there's no institution keeping bitcoin records, and taxpayers may not even know they need to do so themselves.

Also up in the air: whether offshore-account reporting rules apply to bitcoin. Taxpayers with $10,000 or more in non-U.S.-based financial accounts often have to report the accounts to the U.S. even if they don't generate income, or else they risk severe penalties.

A spokesman for FinCen, the U.S. Treasury Department unit charged with preventing financial crimes, says this question is "under consideration and will be made in consultation with the IRS," but it's unclear when. The IRS could face a bigger headache if bitcoin and its kin replace tax havens as the venue of choice for tax evaders, Mr. Marian says.

"Virtual currencies possess the traditional benefits of tax havens: anonymity and no tax," he says. While rules now taking effect are putting pressure on governments and financial institutions to end offshore tax evasion, he adds, "virtual currencies pose a threat to this recent success because they don't depend on banks or governments."

Mr. Marian says that he and many other specialists are "stumped" as to how the IRS will rule on bitcoin. He says his own sense is that it's a commodity similar to gold, because there's a finite supply and it's a store of value. He adds that some bitcoin transactions may be akin to barter—which has its own tricky tax rules.

In the absence of guidance, advisers are telling clients that bitcoin income, gains and losses should be declared to the IRS. "If you take a reasonable position, they probably will accept it," says Jonathan Horn, a certified public accountant in New York. He plans to advise his clients to file foreign account disclosures if they meet certain thresholds and hold bitcoin through an entity that isn't located in the U.S.

Taxpayers who have bitcoin and flout the tax rules, Mr. Horn warns, "are opening themselves to penalties, interest and possible fraud prosecution."

—Email: [email protected]

[Guest Taxed]

I got enough problems with two clients buying Iraq Dinars in the hope to make a killing when the value goes up?

I don't need another Bitcoin investor!

[BulldogTom]

KC,

Do you know how bitcoin works. Do I go out and buy them with cash? Are there a network of goods and services providers that will accept them?

So, could I do a tax return for my client and get paid in bitcoins, then turn around and by toner and paper from a supplier that will accept bitcoin as payment? is that how this works?

Tom

Hollister, CA

[Crank]

What initially concerns me is the $10K in non us account reporting. That is an area we will need to be more through in questioning clients.

[GeneInAlabama]

KC,

Do you know how bitcoin works. Do I go out and buy them with cash? Are there a network of goods and services providers that will accept them?

So, could I do a tax return for my client and get paid in bitcoins, then turn around and by toner and paper from a supplier that will accept bitcoin as payment? is that how this works?

Tom

Hollister, CA

Tom, I belong to a barter club called ITEX that works like what you describe. I prepare a tax return for a member and he pays me with ITEX dollars. I can use those ITEX dollars to buy goods from other members. It does give me extra income but I am limited where I can spend it. It is a nationwide organization so there are quite a few condos available in vacation spots. There are several restaurants in my local area and there is a variety of goods and services that are available. One advantage is that I have very little competition on ITEX. Taxwise, it is the same as cash.

[Guest Taxed]

>> One advantage is that I have very little competition on ITEX. Taxwise, it is the same as cash.

Who keeps track of your ITEX balance? What happens if that website folds?

[kcjenkins]

Mt.Gox is the world's most established Bitcoin exchange. You can quickly and securely trade bitcoins with other people around the world with your local currency!

https://www.mtgox.com/

Simple Bitcoin Converter

updated constantly Prices are now (by default) gathered from multiple Bitcoin markets, and averaged by trade volume.

http://preev.com/

The weakness in existing currencies stems from lack of faith in institutions—particularly central banks, which are often in league with commercial and investment banks. When a government bails out a failed bank or insurance company—in essence, by printing money—the net effect is that the currency as a whole is debased, in favor of a few and at the literal expense of everyone else, which amounts to a fair description of today’s global financial system. Hence the sudden appeal of bitcoins, which appear, for the moment, at least, to be immune to the machinations of inept or crooked bankers and politicians.

In many ways, bitcoins function essentially like any other currency, and are accepted as payment by a growing number of merchants, both online and in the real world. But they are generated at a predetermined rate by an open-source computer program, which was set in motion in January of 2009. This program produced each one of the nearly eleven million bitcoins in circulation (with a total value just over a billion dollars at the current rate of exchange), and it runs on a massive peer-to-peer network of some twenty thousand independent nodes, which are generally very powerful (and expensive) G.P.U. or ASIC computer systems optimized to compete for new bitcoins. (Standards vary, but there seems to be a consensus forming around Bitcoin, capitalized, for the system, the software, and the network it runs on, and bitcoin, lowercase, for the currency itself.)

Bitcoin releases a twenty-five-coin reward to the first node in the network that succeeds in solving a difficult mathematical problem requiring a certain amount of brute-force computation (known as a proof-of-work calculation.) The solution is then broadcast throughout the network, and competition for a new block and its twenty-five-coin reward begins. (There’s a good rundown of the technical aspects of Bitcoin on the Bitcoin wiki; there’s also a wonderfully pellucid explanation of the proof-of-work angle from Paul Bohm, on Quora.)

At first, anyone armed with an ordinary computer could download and run the Bitcoin software and gather (or “mine”) bitcoins. The more computing power you can dedicate to Bitcoin calculations, though, the better your chances of arriving first at each solution. This feature of the system, by design, resulted in a kind of computational arms race that strengthened the network by rewarding increased computing power. Four years into the Bitcoin project, only very powerful, purpose-built machines have enough muscle to keep pace with existing network nodes.

In this way, bitcoins are mined like gold used to be, in quantities that are small relative to the total supply, so that the supply grows slowly. There is an upper limit of twenty-one million new coins built into the software; the last one is projected to be mined in 2140. After that, it is presumed that there will be enough traffic to keep rewards flowing in the form of transaction fees rather than mining new coins. For now, the bitcoins are initially issued to the miners, but are distributed when miners buy things with them or sell them to non-miners (such as jumpy Spanish bank depositors) who desire an alternative currency. The chain of ownership of every bitcoin in circulation is verified and registered with a timestamp on all twenty thousand network nodes. This prevents double spending, since no coin can be exchanged without the authentication of some twenty thousand independent cyber-witnesses. In order to hack the network, you would have to deceive over half of these computers at the same time, a progressively more difficult task and, even today, a very formidable one.

From the first, Bitcoin was devised as a system for removing the possibility of corruption from the issuance and exchange of currency. Or, to put it another way: rather than trusting in governments, central banks, or other third-party institutions to secure the value of the currency and guarantee transactions, Bitcoin would place its trust in mathematics. At the P2P Foundation, Nakamoto wrote a blog post describing the difference between bitcoin and fiat currency:

[bitcoin is] completely decentralized, with no central server or trusted parties, because everything is based on crypto proof instead of trust. The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts… With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.

Much of what has been written so far about bitcoins has centered on the perceived dangers of their relative anonymity, the irreversibility of transactions, and on the fact that they can be used for money laundering and for criminal dealings, such as buying drugs on the encrypted Web site Silk Road. This fearmongering is a red herring, and has so far prevented the rational evaluation of the potential benefits and shortcomings of crypto-currency.

Cash is also anonymous; it is also used in money laundering and illegal transactions. Like bitcoins, stolen cash is difficult to recover, and a cash transaction can’t readily be traced back to the source. Nor is there immediate recourse for the reversal of transactions, as with credit-card chargebacks or bank refunds when one’s identity has been stolen. However, it is difficult to believe that anyone who has written critically of the dangers of bitcoin would prefer an economy where private cash transactions are illegal.

The Bitcoin-software community is loosely governed not by wild-eyed kids camping out in half-deserted lofts but by what appears to be a rational and sober group of adult administrators who run the Bitcoin Foundation. This organization was modelled on the Linux Foundation, according to Gavin Andresen, who is currently the Bitcoin Foundation’s chief scientist. As the lead developer for the project, Andresen is paid a salary by the Bitcoin Foundation. He has been involved full-time in Bitcoin since the spring of 2011.

Like the Linux Foundation, the Bitcoin Foundation is funded mainly through grants made by for-profit companies, such as the Mt. Gox exchange, Bitinstant, and CoinLab, who depend on the stability and continued maintenance of the underlying open-source code.

“The Linux Foundation provides a bit of a center for Linux, and to pay the lead developer, Linus Torvalds, so that he can do nothing but concentrate on the kernel,” Andresen said. “It’s a tricky thing, once you get to be a certain size as an open-source project, how do you sustain yourself? Linux is the most successful open-source project in the world, so we thought it would make sense to use that as a model.”

And the Financial Crimes Enforcement Network (FinCEN), the federal agency that enforces laws against money laundering, announced new guidelines requiring certain “virtual currency” trading entities to register as Money Services Businesses (M.S.B.s). Though the Bitcoin Foundation’s general counsel, Patrick Murck, was somewhat critical of the new guidelines, this move went a certain distance toward calming Bitcoin speculators and others who’d been worried that the government would take more drastic steps against the mining, transfer, and exchange of bitcoins.

Gavin Andresen is among those who sees the new FinCEN guidelines as a positive development.

In my opinion, the FinCEN guidance is fantastic news: it gives Bitcoin users and businesses clear rules on how they will or won’t be regulated. It is great for ordinary users, because FinCEN said that using bitcoins to buy products or services is perfectly legal. And, long-term, it is great for businesses, because they now know how FinCEN will classify them and what regulations they must obey here in the U.S. That said, it might cause problems for some smaller U.S. bitcoin-based businesses, who might have been hoping that they wouldn’t be regulated at all. The bigger bitcoin businesses have been anticipating this for a while, so I don’t think it will affect them.

[kcjenkins]

The common picture of bitcoin users has been that they’re all long-haired anarchists, libertarians, and weirdos who would do away with government entirely, if they could. But in response to a question about his politics, Mike Caldwell had this to say:

I am not an anarchist; I believe in the rule of law and a civilized society. But I also believe that unchecked power is a threat to the common good, and that anything that the public can do to challenge that power is a benefit to society. As an individual, if you accept bitcoin in exchange for your goods or your work, that is a vote for economic fairness.

So is bitcoin going to save the global economy, or is it today’s answer to seventeenth-century tulip mania? Gavin Andresen offered a word of caution.

I still tell people that Bitcoin is an experiment: only invest time or money you can afford to lose, because Bitcoin is still an experiment. The longer it keeps going in the face of volatility and technical glitches happening, the more we’ll know.

But trust takes time.

[GeneInAlabama]

>>Who keeps track of your ITEX balance? What happens if that website folds?<<

ITEX is the "banker". They keep track of everything. Of course they charge a fee for what they do. $30 per month plus 6% of your sales and 6% of your purchases for a total of 12%. I consider the 12% cost as a discount for new business. It is business I would most likely not get if I wasn't on ITEX.

As for the company folding - I have been with them for about 10 years and they were strong when I started with them and they remain strong. They cover the US and Canada.

Over the last 3 or 4 years, I have spent several thousand ITEX dollars with dentists that I would have otherwise had to spend cash.

It has worked great for me.

[kcjenkins]

Interesting. Thanks for that info. I think we are at the early stages of this, but I do believe it's going to be growing, as even the major countries play games with their currency.

ITEX is not in every state, but where it is active, it does make sense. Guess we need to be aware of where it is, and be sure to ask the 'bartering question' to all our clients if in such an area.

[Catherine]

And for some of the *dangers* of bitcoin...

http://market-ticker.org/akcs-www?post=227045

[Guest Taxed]

Anyone else have clients that invest in Iraq Dinars? I have a feeling I got to do either a Sch D with some serious loss or a form 4684 this season for my 2 clients!

How will you be handling those situations?

[Kea]

I have a few clients who have accounts in Indian rupees. The main impact so far is that 2 of them are now subject to F-Bar. Each of them travels there periodically to visit family, so it's more convenient to maintain an account there. One have them also owns real estate there.

[jshtax]

I got enough problems with two clients buying Iraq Dinars in the hope to make a killing when the value goes up?

I don't need another Bitcoin investor!

The Dinar is worthless and will always be worthless as it is a scam. The bitcoin on the other hand has some value.