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The Shifting Sands of Bitcoin Taxation 

March 20, 2018

The rise of bitcoin and other cryptocurrencies has brought about a whole new set of fascinating taxation issues. Currently, the market value of bitcoin is in the low $8,000 range, as of today it is approximately $8,270. Its value has fluctuated widely over the past several years. At its peak, bitcoin boasted a market price of roughly $19,000, which is quite an impressive improvement when you consider its humble beginnings.

Though a large percentage of Americans are unfamiliar with bitcoin, news about it is spreading fast. Further, it seems likely that the word about it will continue to travel at a healthy pace. Even in the face of a bitcoin failure or outlawing, one of its competitors will likely rise and fill the void. Although they’re still minor players in the financial world, cryptocurrencies are here to stay. This post address some of the murky taxation issues surrounding them.  

Investment Property

Fortunately for us, the IRS and SEC have gradually become involved and are starting to pay closer attention to cryptocurrencies. The IRS released a document, Notice 2014-21, in which it stated that it will treat bitcoin as “investment property”. The notice states that it triggers either capital gains or ordinary income, depending on how taxpayers hold and use it. Though this document has helped to clarify some issues surrounding bitcoin, the full picture is still emerging. No doubt, it will take quite a bit of time to settle everything.

Bitcoin Mechanics 

Bitcoin is a “digital currency” (or “virtual currency”) which means that it does not have possess physical attributes. To possess bitcoin means having the ability to transfer bitcoin to another person or entity. Bitcoin holders store their currency in a “digital wallet” which has its own security key to deter or avoid theft. On its surface, the mechanics of bitcoin seem fairly straightforward: to use their currency, bitcoin users simply transfer a fixed quantity of bitcoins to a third party and then receive the goods or services which they bargained for to complete the transaction. Underneath the surface, however, the mechanics of bitcoin get a bit more complicated. 

Verification

Since bitcoin is its own standalone currency, and is entirely digital, it requires a sophisticated system to make it functional. When a bitcoin user transfers currency from his or her digital wallet, this transaction has to be “verified”. This process ensures that the user actually has possession of the bitcoins sent. Transactions are verified when other people outside of the transaction use computer power to solve incredibly complicated cryptographic puzzles. When a transaction is verified, it is logged into a public ledger called a “blockchain”. When a transaction is verified, this act also results in the creation of bitcoin. That’s because whoever solves the puzzle receives additional bitcoin as a reward. Hence, bitcoin is totally self-sustaining. In other words, it is capable of perpetuating itself without any government involvement or other kind of supervisory authority.  

Issues with Bitcoin Taxation 

IRS Notice 2014-21 did a lot to clarify how bitcoin will be treated for federal income tax purposes. The IRS now classifies bitcoin as investment property. Accordingly, bitcoin taxation is handled much like that of other investment properties (e.g., stocks, bonds, notes, etc.). Whether bitcoin is taxed at the capital gains rate or ordinary income rate depends on how it is acquired and held. For instance, if a person “mines” bitcoin, which is the term used to describe the process of verifying bitcoin transactions for the purpose of generating more bitcoins,  it is taxed as ordinary income upon receipt. Further, if an individual were to mine bitcoin as a business or trade, then the receipt of bitcoin would trigger self-employment income tax. 

Intent

If, however, acquisition of bitcoin and intent to hold as an investment can be firmly established, it is treated as a capital asset and taxed at applicable capital gains rates. Things get tricky, though, when mining bitcoin or receiving it as wages. That’s because in either case its fair market is necessary for tax purposes. Bitcoin’s market value tends to be quite unstable, and so recipients would need to determine precisely the convertible value of bitcoin in U.S. dollars prior to paying tax. If someone mines or receives bitcoin as wages, and then subsequently holds the bitcoin for investment, the bitcoin is first taxed as ordinary income. Later it is taxable at the capital gains rate when it is eventually cashed out. 

Exchanges

There are other other issues as well. One is whether an exchange of bitcoin for other cryptocurrencies are legitimate transactions under IRC Section 1031. Following the 2018 Tax Cuts & Jobs Act, only real estate exchanges are permissible under Section 1031. Notwithstanding that fact, bitcoin exchanged earlier may still pass inspection as personal property exchanges. Whether these transactions hold up to IRS scrutiny depends on evolving regulations.

Call Us For Assistance!

If you’re presently in possession of bitcoin or might come to acquire some, it’s best to consult with professionals. It’s important to document your transactions for tax purposes and, clearly, that can be tricky. Taxation issues are difficult enough to deal with when they involve matters familiar to most of us. It follows, therefore, that they can be downright maddening if they involve something as unusual as bitcoin taxation. Luckily, the tax attorneys at Mackay, Caswell & Callahan, P.C. stay up-to-date with cutting edge issues. We’re more than happy to assist you with your bitcoin taxation query. Contact us today to speak to a highly experienced New York tax attorney! 

Image credit: www.cafecredit.com 

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