As a leading public accounting firm in the virtual currency space, we regularly field inquiries from clients and potential clients relating to taxation of virtual currencies in the United States. Here is a list of the most common misconceptions held by virtual currency users that we encounter in our work, and the answers that we provide.
Myth: Virtual currencies aren’t taxable.
Fact: The US system of income taxation is broad and far-reaching. Almost all income realized during the year, anywhere in the world, must be recognized for income tax purposes. Section 61 of the Internal Revenue Code defines gross income as: “all income from whatever source derived, including (but not limited to) compensation for services, income from a business, gains derived from dealings in property, interest, rents, royalties, dividends, alimony and separate maintenance payments, annuities, income from life insurance and endowment contracts, pensions, income from discharge of indebtedness, distributive share of partnership gross income, income in respect of a decedent, and income from an interest in an estate or trust.”
Virtual currency activity falls into IRC Section 61(a)(3) “gains derived from dealings in property.”
Myth: Virtual currencies are so new that no one knows what to do with them.
Fact: Bitcoin, introduced in 2009, currently boasts the largest market capitalization among virtual currencies and is likely the best known. However, virtual currencies have been around in some form for many years.
In early 2014, the IRS provided initial guidance relating to virtual currency taxation with Notice 2014-21. The notice states that virtual currencies are treated as property in the hands of US taxpayers. This means that the existing taxation framework relating to transfers of property also applies to virtual currencies.
How property treatment applies depends on how virtual currencies are used in each individual case. While most taxpayers would recognize virtual currency holdings as capital assets with capital gain or loss, a dealer or broker might recognize holdings as inventory or stock in trade.
Myth: Tax laws related to virtual currency change all the time.
Fact: Federal tax law relating to virtual currencies is neither ambiguous nor expected to change significantly in the near future. We are not aware of any serious effort to liberalize or reform tax rules as they relate to virtual currency.
Myth: Reporting virtual currency on a US tax return guarantees an audit by the IRS.
Fact: A US taxpayer has less than a 1% chance of being selected for an audit for any tax year. Since 2013, we have prepared and filed hundreds of tax returns reporting virtual currency activity. To our knowledge, zero returns with virtual currency prepared by our firm have been selected for audit. This doesn’t mean that our work is impervious to audit, only that audits are rare overall and virtual currencies don’t seem to be a high enforcement priority for the IRS. In fact, the Treasury Inspector General for Tax Administration recently criticized IRS enforcement as uncoordinated and generally ineffective.
Myth: Virtual currency gains are not taxable unless coins are converted to US Dollars.
Fact: All disposals of capital assets or other income generating transactions during the tax year must be reported at tax time. Disposals include any transaction where an asset is exchanged for any other asset. For example, trading bitcoin for ether results in a reportable disposal of bitcoin at its current US dollar value and a simultaneous purchase of ether at its US dollar value.
Myth: Trades among virtual currencies are considered “like-kind,” and not reportable or taxable.
Fact: Internal Revenue Code Section 1031 permits deferral of gain on certain disposals of capital assets. In most cases, virtual currencies are not explicitly excluded from Section 1031. However, Section 1031 has detailed rules governing timing, identification of the asset to be disposed, and the asset acquired, and also requires an extra filing for every transaction where deferral of gain is claimed. As a result, claiming treatment under Section 1031 is likely impractical for most taxpayers.
If you have questions about your personal situation with regard to virtual currency taxation (or any other issue), please contact us.