Bitcoin is the most popular virtual currency today, making headlines lately as its value has increased from a few cents in 2010 to over $2,900 in June of 2017. But what is a “Bitcoin?” How does the tax code treat this “currency” which is not backed by any government?
What is a Bitcoin?
Bitcoin is the first and most popular “cryptocurrency.” It is an open source, peer-to-peer electronic money and payment network. Some benefits of using Bitcoin are that it is easy to initiate, it is anonymous, there are usually no transaction fees, it’s fast, and transactions are final. Many other cryptocurrencies exist including Litecoin, Ripple and Ethereum.
In order to use Bitcoin, users install Bitcoin software on their computer and setup a “wallet” which is used to engage in transactions. A user needs both a public and a private key to initiate a transaction from their wallet. The public key is viewable by any user, but the private key is known only to the user and is used to authorize transactions.
When a transaction is executed, it is recorded on the block chain, which acts as a ledger that anyone can look at. The block chain contains information on every transaction ever executed in the currency, including how much value belonged to each address (the combination of a public and private key) at any point in history. The block chain is anonymous as the addresses are not connected with any individual. The Bitcoin is then transferred from the wallet of the sender to the wallet of the receiver.
In the same way a US dollar can be divided into 100 cents, a Bitcoin can be divided as well. Instead of being divided into one hundred parts like the dollar, a Bitcoin can be divided by 100 million units called Satoshis.
There is a finite limit of 21 million Bitcoin in existence with only 12 million currently in circulation. This leaves 9 million waiting to be mined. Mining occurs when a transaction is initiated and is recorded to the block chain. Instead of charging a transaction fee to the user, a “miner” applies a complex computer algorithm to the transaction in order to record the transaction to the block chain. Once the transaction is recorded to the block chain, the “miner” is rewarded with new Bitcoin.
Bitcoins can be purchased online using credit cards from companies like Coinbase and Circle. They can also be purchased through a Bitcoin ATM, or by using an exchange such as Local Bitcoins where users can arrange to meet up with someone to exchange cash (or other currency) for Bitcoin. At the moment, Bitcoin is not available for direct purchase using a traditional brokerage account, but if a user wants exposure to Bitcoin through their brokerage account there are investment trusts which track the price of Bitcoin.
How does Bitcoin impact my tax situation?
If a taxpayer receives Bitcoin in exchange for goods or services, the taxpayer is required to include the amount in their gross income when calculating their tax liability. This is done by calculating what the value of the Bitcoin received would be in US dollars based on the rate of exchange on the date of the transaction.
Generally, if the taxpayer is holding Bitcoin for investment purposes, it is a capital asset. The taxpayer will have a gain or loss when they exchange their Bitcoin for currency or other property.
Unlike other forms of currency, Bitcoin is considered property for federal income tax purposes. This means that if the taxpayer’s Bitcoin changes value (even slightly) in relation to the US Dollar, a taxable gain or loss will occur if the Bitcoin is exchanged for other property or into another currency. This is unlike a foreign currency transaction which would exempt these kinds of gains and losses (as long as they are below $200).
For example: On day one, a taxpayer buys Bitcoin valued at $20 dollars. On day two, the Bitcoin is worth $21 dollars and the taxpayer decides to spend his/her Bitcoin on groceries. The taxpayer now has a taxable capital gain of $1.
If this transaction had been made in a foreign currency instead of Bitcoin, the gain would fall below the threshold for gains on foreign currency.
Foreign transaction reporting: if a taxpayer has an interest in more than $10,000 worth of Bitcoin they may be required to file a Report of Foreign Bank and Financial Accounts.
If you have any questions regarding this or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.