Tax season is right around the corner, and most Americans are getting their W2s and paperwork ready.
And as virtual currency like Bitcoin becomes increasingly intertwined in consumer and corporate culture, the Internal Revenue Service may struggle to regulate and prosecute digital scofflaws.
But for the latest Bitcoin miners and traders trying to cash in on the cryptocurrency craze, the burden of staying within the complicated boundaries of the law are on them.
The IRS treats Bitcoin that is ‘mined’ differently than Bitcoin that is ‘bought’
In order to obtain Bitcoin, you can either buy it on an exchange or you can “mine” for it using a computer.
“This is going to create a headache for some people,” says Annette Nellen, a professor at the San Jose State University College of Business. “If you mine the Bitcoin, that’s a separate issue.”
For the IRS, buying Bitcoin has a completely different classification than Bitcoin after it is mined.
For those who buy it, virtual currency is not treated as cash; it is treated as property. This means that the treatment of foreign paper currency like yen or euros is different, in the eyes of the IRS, than Bitcoin.
For those who mine it, the miner recognises income when that Bitcoin is mined, says a tax expert quoted by TechCrunch. And the price when it is mined is the basis for which the miner can calculate a gain or loss when they sell it. But the expenses attributable to mining those Bitcoin are also deductible.
So while investors like the Winklevoss twins — who have set up an ambitious Bitcoin fund and also plan to launch this year an exchange called Gemini — are not required to pay taxes on the Bitcoin they have amassed until they sell it, the same might not apply to Satoshi Nakamoto, rumoured to be the individual who developed the currency. (Nakamoto, of course, was outed in a Newsweek profile he has challenged, and was subsequently victimized by hackers.)
Bitcoin investors will need detailed records of transactions
Having your Bitcoin taxed might be a particularly painful process, especially if you haven’t been doing your homework all along, Nellen says (tax day preppers can view the IRS’ latest regulations here and here).
Because it’s treated as property, and not as currency, it means owners have to track the price of it from when they buy it until when it is sold or used. Because there is no set price for the digital currency, as it trades on numerous exchanges, investors may even want to break down purchases by where it was acquired.
If a person buys Bitcoin and later uses it to pay someone for a service, they will need to track the value of the currency at the time they bought it, and when they used it as payment — the recipient will need to do the same, Nellen said.
And, for another thing, many owners of Bitcoin — who had to pay taxes after the digital currency saw its value soar across 2013, until late in the year — won’t have to pay anything based on the falling value of the currency during 2014.
However, those that made money investing in Bitcoin will have to pay taxes on their paper gains.
Nellen said that businesses accepting Bitcoin — like Overstock, which was among the first companies to start taking the digital currency — or, Dell, will have to abide by the same rules as Bitcoin buyers — as long as the company has been holding, and profiting from, digital currency.
Still, she acknowledges, both legislation and regulation pertaining to virtual currency and Bitcoin has barely entered its infancy — and more rules could be on the way, especially if it proves too difficult to efficiently track.