Bitcoin, the popular digital currency, went on a tear in 2017, rising in value by 900% in the first 11 months. More and more investors are taking notice. On November 30 The Wall Street Journal ran a front-page article, “Bitcoin Mania: Even Grandma Is In.” On the advice of her grandson, Rita Scott invested a few hundred dollars in bitcoin in October and was 45% ahead when she sold the position a few weeks later.
To some extent, the popularity of bitcoin may be driven by bad assumptions about the tax implications of investing in it.
The IRS Weighs In
In March 2014, the IRS delivered its views on the emergence of digital currencies. The most important observation was that a digital currency such as bitcoin is property, not currency. As such, it has a tax basis. Using bitcoin in making payments will generate taxable events, a major defect in using it for routine transactions.
For example, assume an individual used a bitcoin acquired for $1,000 in January 2017 to buy something today worth $10,000. Seems like quite a bargain. But the use of the bitcoin in this situation generates a taxable gain of $9,000, the difference between the $1,000 basis and the $10,000 value of the transaction. That amount will be subject to income tax. The tax may be at capital gain rates if the bitcoin is a capital asset in the hands of the owner. On the flip side, should the value of bitcoin go down, a subsequent loss by the investor may or may not be deductible.
The Service clarified that bitcoins won’t be an avenue to avoiding other tax rules. For example, bitcoins received by an independent contractor for performing services will be considered self-employment income, subject to self-employment tax as well as income taxes. If wages are paid in bitcoins, they are still subject to employment taxes. Payments made in bitcoin are subject to the same information-reporting requirements as payments made in dollars. Payments made in virtual currencies are subject to backup withholding in a manner similar to payments in dollars.
Finally, the IRS warns that tax penalties will apply, including accuracy-related penalties and penalties for failure to file information returns when required.
To pursue cases of tax evasion related to bitcoin, the IRS sought access to the records of Coinbase, a major bitcoin exchange. Coinbase sought to bar or limit that access, but they were only partially successful. A U.S. District Court judge ruled in late November that Coinbase must turn over to the IRS the records of any client who had at least one bitcoin transaction worth $20,000 or more. Coinbase has 14,355 such users among its 6 million clients, but only 800 to 900 have been reporting their bitcoin transactions to the IRS. The Court ruled that the IRS’ suspicion of tax avoidance was justified.
Before the ruling was announced, bitcoin had reached $11,000. When the news broke, the price fell by $2,000 immediately, but later recovered somewhat.