Bitcoin At Tax Time: What You Need To Know About Trading, Tipping, Mining And More
If you have come into possession of Bitcoin or any other digital currency such as Ripple or Litecoin that is “convertible” to a real currency or can be used to pay for goods and services, it may seem virtual. But the Internal Revenue Service considers it very real and you need to account for it at tax time.
“If you’re not doing the accounting [on your digital currencies], you are on the line for tax evasion or misfiling,” says Jake Benson, CEO and founder of Libra Tax, which offers accounting software for digital currencies. “The reason you’d want to account for your Bitcoin and the gains and losses is the exact same reason you need to do it when you trade stocks. If you don’t, you’re breaking the law.”
According to IRS guidance notice 14-21, Bitcoin and cryptocurrencies are capital assets, similar to stocks and bonds. “That means that for Bitcoin, and any existing cryptocurrency, the framework that applies to gains and losses, and the taxation and accounting of capital assets applies to cryptocurrency too,” says Benson.
However, since stocks, bonds and other capital assets are not usually used as an everyday payment mechanism the way that Bitcoin and virtual currencies are, that introduces some complications.
Here are the seven ways you may come into possession and/or dispose of Bitcoin and other digital currencies and how you need to account for them at tax time, plus explorations of two major gray areas. (For expediency, the article will refer mostly to Bitcoin, but the rules apply to all virtual currencies.)
1. Mining
New Bitcoin are being issued by the system roughly every 10 minutes by a process called mining. In mining, computers running the Bitcoin software around the world attempt to solve math problems and the first computer to come up with the solution adds the most recent transactions to the ledger of all Bitcoin transactions, plus receives the new bitcoins created by the system, called the block reward.
If you are a miner and win the block reward, you must record the fair market value of Bitcoin that day and mark that as an addition to your personal or business income. Also note the date and timestamp at which your coins were mined. Later, when you dispose of those Bitcoin, you will subtract the date of acquisition from the date of disposal, and you will be taxed a long-term capital gains rate on any Bitcoin you held for more than a year, and a short-term capital gains rate on any Bitcoin you held for a year or less. (The timestamp isn’t absolutely necessary, but is helpful to validate the order of multiple acquisitions or disposals within a day.)
The amount you pay in taxes on a long-term capital gain will depend on your income-tax bracket, while short-term capital gains are taxed the same as ordinary income.
2. Minting
Minting is when other digital currencies are created out of thin air. Then the company or person creating the protocol or technology behind this new virtual currency needs to record the same information: the fair market value of the new currency when the currency is created (usually zero), plus the date and time stamp at which the coins were minted. Again, the fair market value is counted as an addition to your income in the year it was minted. And the date of acquisition needs to be noted, so that you can determine whether you will pay a short- or long-term capital gains tax on it.
3. Earning
If you receive Bitcoin via payroll, just as in mining, it’s treated as an income event. Again, record the date and the fair market value. Later on, you will pay short- or long-term capital gains tax when you dispose of it.
However, if you earned the Bitcoin in exchange for goods or services, you can also record your basis as the value of the item that you received for it. For instance, if Bob does $2,000 worth of services for Alice, and Alice pays him 5 bitcoins, the total of which is, at press time, higher than $2,000, he can record his cost basis (the amount at which he received it) as $2,000. He will pay less in taxable income upon receiving the bitcoins, but then more in capital gains tax if the price has risen by the time he sells.
4. Spending
Spending Bitcoin, whether you’re buying a coffee or a Dell computer, is treated just like selling. You record a short- or long-term capital gain or loss, based on your original cost basis and your holding period. (While this may seem onerous, see “Deciding Which Bitcoin Is Being Disposed Of” below for how to record these details.)
5. Tipping/Gifting
What people commonly call tipping on the Internet does not fit the IRS definition. “The law defines tips in a special way that applies to a pretty small group of scenarios [and considers tips] regular wage data, basically applying to waiters and people in the service industry,” says Benson. “Even though people on the Internet call gifts back and forth tips, by the letter of the law, they actually fall into the category of gifting.”
So, when people send tips on the Internet via a service like ChangeTip, which allows people to send each other small amounts such as $3, $1 or $0.25, the sender of the tip is considered a gifter, and whatever gain or loss he has experienced is then transferred onto the receiver.
“If I acquire it at $10 and it goes to $20 and I give it to you and it later went to $30 and you sold it, even though it only went from $20 to $30 in your possession, since I gave it to you, you inherit my holding period and cost basis,” says Benson. “At the moment you sold it for $30, you technically have to recognize the gain from $10 to $30.”
However, in reality, very few people will know the cost basis and holding period of any tips they receive, unless the gifter tells them. For that reason, most recipients of tips should assume a cost basis of zero and recognize the entire tip as income.
If you send a tip, you can help out the recipient, by telling him or her your cost basis and holding period. However, few, if any, people are actually doing this. And since the recipient of a tip may then tip someone else with the same money before paying taxes on it, the cost basis and holding period would need to be transferred again from the original tipper. Since it’s possible that tips could actually change hands many times within a given year, it could be nearly impossible to track down this information. For any tips you still have at the end of the year, declare it all as income to pay the highest possible amount of taxes on it.
If you are gifting Bitcoin to someone, you will not pay taxes on gifts up to $14,000 per year per recipient. However, it’s best for the receiver if you tell her the cost basis and date of the acquisition, especially if you are gifting her a large amount.
If you are the recipient of a gift, you can ask the giver for the cost basis and holding period, but if you can’t find out, you should record it all as income.
6. Trading
Like the buying and selling of a stock, when you trade for Bitcoin, there’s no immediate taxable event, but you have to record the fair market value and the date. The taxable event occurs upon disposition — either when you sell it or pay with it.
Because this is a new industry, if you are trading, you should check with your exchange to find out if it issues a 1099-B report at the end of the year, which will identify your gains and losses. Among some of the major digital currency exchanges — ItBit, Coinbase and Gemini — itBit releases 1099-Bs to its users, Coinbase sends out “a specialized Cost Basis for Taxes report” plus has a partner integration with LibraTax, and Gemini’s CEO and cofounder Tyler Winklevoss said by email, “we will deliver to our customers the appropriate information prior to April 15, 2016 so our customers can comply with applicable federal tax law.”
7. Donating
If you have appreciated coins that you’ve held for more than one year, you can avoid paying taxes on the gains by donating those coins to a registered 501(c)3 charity that takes Bitcoin (such as United Way, Save the Children, Greenpeace, BitGive and others) and getting a proper receipt. Then, you can write off the total amount of the donation. For instance, says Benson, “If you mined a coin worth $0 and it goes up to $500, and you donate that coin, you get to write off a $500 donation but you don’t have to report $500 in gains.” That reduces your taxable income. To optimize your tax payment, you should donate the most appreciated coins to avoid paying taxes on them and to get the greatest deduction.
If you would like to donate coins you’ve held short term, it’s best to convert them to another currency (like USD) and donate that instead. Then you’ll pay short-term capital gains on the sale, but you’ll be able to write off the full amount of the donation. (If you just gave the Bitcoin you’ve held short-term, you’d only be able to write off the cost basis, not the full amount of the donation, and if the currency has risen in a short time, then your deduction will be smaller than it could’ve been.)
Deciding Which Bitcoin Is Being Disposed Of
The difficulty of all these rules is that, in any particular disposal scenario, you may not know which particular Bitcoin you are spending, tipping, gifting, donating, etc. “Think of [Bitcoin] as liquid. If you poured two Bitcoin into the same wallet/glass, it’s just mixed liquid and there’s no way to really separate those two glasses you mixed together,” Benson says.
For that reason, it’s more practical to use one of the two common accounting methods: last in, first out (LIFO), or first in, first out (FIFO). In LIFO, you always assume disposal of your newest asset or coin. In FIFO, you always assume disposal of your oldest.
Individuals can change their accounting method from year to year. So if the price of Bitcoin or your digital currency has risen over the year, LIFO is ideal. That will help minimize your gains and the taxes you will pay on them. If the price is falling however, then go with FIFO, because you can maximize your losses and claim a deduction, which will reduce your taxable income.
Businesses, however, can’t switch from year to year. They usually have to choose an accounting method and stick to it.
Another option is to use what’s called “specific share identification.” If your records are in good enough order, every single time you dispose of an asset, you can select the highest cost one to either maximize a loss (and your tax deduction), or realize a smaller gain (and minimize your tax). Benson’s software offers an option called Libra Optimize, which, instead of using LIFO or FIFO, will mathematically reduce your tax obligation using this methodology.
Gray Area 1: Wash Sale Rules
The IRS prohibits taxpayers from deducting from their taxes the losses of so-called wash sales, in which you sell a security to realize a tax loss but then purchase a replacement 30 days before or after that sale. Currently, wash sale rules do not apply to Bitcoin and other cryptocurrencies, but Tyson Cross, a tax attorney at Cross Law and founder of Bitcoin Tax Solutions, cautions that if the IRS does decide to apply wash sale rules in this area, it could do so retroactively. But that doesn’t necessarily mean that the IRS is correct.
“If you find yourself in a situation of having the IRS saying wash sale rules apply to you, you are free to challenge that interpretation,” says Cross. You would go to Tax Court and say you disagree with the IRS’s interpretation, leaving it for a judge to decide. Because the wording of the statute clearly applies only to stocks and securities, Cross thinks it’s unlikely the IRS will take that interpretation. But if it did, and a taxpayer disagreed and prevailed in court, “the IRS would have to ask Congress to change the wording of that statute, and that act would not be retroactive.” So if Congress ever changes the statute to apply wash sale rules to Bitcoin, that rule would only apply from that day going forward. (If a taxpayer prevails and Congress doesn’t rule, it’s not clear what that would mean for other Bitcoin-holding taxpayers. In some cases, the Tax Court decision could apply only to that taxpayer, and in others, it could make other taxpayers feel comfortable using the same interpretation. “You don’t get real resolution on tax matters until you go to the Supreme Court,” says Cross.)
Gray Area 2: Loss Of Bitcoin
How you should treat a loss of Bitcoin for tax purposes depends on the particular circumstances of your loss, so you should always consult a tax professional in these instances. However, generally, if you lose the private keys to your Bitcoin or have a hardware failure, you can deduct your losses under section 165 of the Internal Revenue Code, which covers casualty and theft losses.
In this case, the value lost would not be the current market value of your Bitcoin, but the amount for which you bought your Bitcoin. Then, you would take $100 off that number and then reduce that by 10% of your adjusted gross income. So if your AGI is $50,000 and you lose Bitcoin for which you paid $5,000, you cannot deduct a loss.
“If the exchange loses your coins, that’s a little messier,” says Cross. “It might implicate theft, and the theft situation is more complicated to qualify for. It needs to be an illegal act … and it’s very difficult to prove that theft actually happened. Oftentimes, people running the exchange have excuses and they say it was a hack, so it’s hard to hammer down the details, especially since these things are occurring in far-off jurisdictions.” Plus, as in the case of Mt. Gox, it’s uncertain where the coins are and if they will be recovered. However, if you want to qualify for theft, try to make a reasonable case that your coins were stolen and that you cannot retrieve them, and document your proof carefully.
A recent decision (Pilgrim’s Pride) in the Fifth Circuit Court, which covers Mississippi, Louisiana and Texas, involved stock, but offers an alternative that could have implications for Bitcoin. A company had shares of stock that had declined significantly — roughly $100 million to $20 million. The company decided to abandon its shares of the stock, because it was financially more advantageous tax-wise for the company to claim a $100 million loss than to keep the $20 million and claim an $80 million loss. Plus, it allowed the company to avoid limitations on capital losses that say you can only deduct $3,000 a year in capital losses.
Someone who had bitcoins at Mt. Gox could formally abandon their bitcoins by sending notice to Mt. Gox that they relinquish their right to their coins and forever waive any claim. Under the logic ofPilgrim’s Pride, they would then be able to take an ordinary loss reduction on their tax return for the amount for which they purchased their bitcoin, and that would be free of both the capital loss limitation that says you can only deduct $3,000 a year in capital losses as well as the casualty loss limitation that requires you to decrease your deduction by 10% of your AGI and $100.
“The big caveat here is that this decision came out of the Fifth Circuit Court of Appeals, so it’s only binding for people in [Texas, Louisiana and Mississippi] and the IRS may disagree with you,” says Cross. “If you don’t live in the Fifth Circuit, it’s a gamble.”
If usage of digital currencies continues to grow, the IRS may clear up some of these gray areas for all Bitcoin-holding taxpayers.
Source: Forbes – Bitcoin At Tax Time: What You Need To Know About Trading, Tipping, Mining And More
