IRS Ruling Could Have Big Impact for Bitcoin Traders

In a ruling that could have significant impact on the tax status of bitcoin holders, the U.S. Internal Revenue Service has ruled that, at least for tax purposes, it considers bitcoin to be property. In a March 25 news release, the IRS stated, “General tax principles that apply to property transactions apply to transactions using virtual currency.”
The agency also said that wages and other payments in bitcoin or other virtual currencies are taxable and subject to the same reporting requirements as payments in any other sort of property.
The ruling is a good news/bad news situation for bitcoiners, depending on where their activity falls. One immediate benefit is that since it’s considered property, bitcoin is no longer subject to the complicated rules of foreign currency gains and losses. This can have a significant impact since many bitcoin holdings are in offshore exchanges that would be subject to the foreign currency rules prior to the ruling. It also avoids the complicated currency taxation in which 60% of profits are taxed as capital gains and 40% are considered ordinary income for most taxpayers.
Because bitcoin is property, its change in value is considered a capital gain or loss and taxed at the appropriate long- or short-term rate. Given the dramatic rise in bitcoin value over the course of 2013, this could means substantial tax savings for an investor who held the currency for a longer period. It could also be beneficial for those who bought at the top of the market and suffered substantial losses.
The news isn’t all good, though, depending on how you spend or hold bitcoins.
Because it’s property and subject to capital gains tax, if you had acquired $5,000 in bitcoin value, for instance, and it doubled in value to $10,000 while you held it, when you spend it, you might be subject to capital gains tax on the $5,000 gain. Because this technically applies to even small transactions (buying a sandwich at Subway, for instance), complying with the letter of the law could be a nightmare.
If you pay or receive wages in bitcoin, those payments are subject to reporting and withholding requirements like any other payroll payments and are considered ordinary income to the receiver.
The property ruling also has impact on those who acquire bitcoins as a business or hobby. The first consideration is whether your activity qualifies as a business. The IRS generally requires that a business must have profit as an objective and have expectations of making a profit in three of the ensuing five years. Otherwise, the activity is considered a hobby.
For a hobby, losses and expenses are only deductible to the extent that they offset gains. A business may show an ongoing net loss for tax purposes, and legitimate business expenses are deductible. This includes expenses for bitcoin mining equipment (which may need to be capitalized), office space, and operating expenses. At the same time, you may be subject to self-employment tax, depending on how the business is structured.
For U.S. taxpayers, it is important to understand how this ruling affects their filings. Not all accountants and tax services will have the knowledge to navigate this new terrain, so for bitcoin traders, it’s important to find one that does.
The final bit of good/bad news is that for those hoping to see bitcoin and other virtual currencies go mainstream, this ruling and similar ones in countries like Brazil may be a major validation. The bad news, of course, is that as the currency gains recognition, the taxman is paying increasing attention.