Virtual currency has gone mainstream. AT&T recently announced that its customers can use Bitcoin to pay their phone bills. Other big companies that accept Bitcoin include Microsoft, Expedia and Overstock. Competitors likely will follow suit. However, using virtual currency has tax implications that may surprise you. Here are answers to some FAQs on this subject.
- What Is Virtual Currency?
Virtual currency is "digital money" that's usually issued and controlled by software developers and accepted as payment by willing parties. Also known as cryptocurrencies, virtual currencies can be transferred, stored or traded electronically. Bitcoin is a common example.
You can use virtual currencies to make online payments to willing providers of goods and services. You can also hold them for speculative investment.
In 2014, the European Banking Authority described virtual currency as a "digital representation of value" that isn't issued by a central bank or public authority, but it may be accepted by some as a means of payment. In other words, virtual currencies are unregulated — unlike currencies issued and controlled by governments and central banks.
- How Is Virtual Currency Treated for Tax Purposes?
The IRS takes the position that virtual currency is "property" for federal income tax purposes. Unfortunately, that means you're supposed to recognize taxable gain or loss every time you exchange virtual currency for goods or services or for U.S. dollars.
Depending on the circumstances, a virtual currency holding can be classified as business property, investment property or personal-use property. If you fail to report virtual currency transactions on your tax return and get audited, you could face interest and penalties and even criminal prosecution in extreme cases.
- How Do I Translate Virtual Currency into U.S. Dollars?
For tax purposes, you'll need to calculate the fair market value (FMV), measured in U.S. dollars, of the currency as of the date you receive or pay it. The values of the most-popular virtual currencies are listed on exchanges. For example, Bitcoin and three other virtual currencies are listed on the Coinbase exchange.
To calculate the FMV of virtual currency, look up the listed exchange rate and convert it into U.S. dollars. For example, at the time this was written, 1 Bitcoin translated into $9,948.95. Or $1 translated into 0.000101 Bitcoin. If you bought one Bitcoin with U.S. dollars at this price, your tax basis in the Bitcoin would be $9,948.95.
- How Are Virtual Currency Transactions Reported for Tax Purposes?
When you exchange virtual currency for other property (including U.S. dollars), you must recognize taxable gain or loss. You'll have a taxable gain if the FMV of the property you receive exceeds your basis in the virtual currency. You'll have a loss for tax purposes if the FMV of the property you receive is less than your basis in the virtual currency. If the virtual currency was held for investment purposes for more than one year, any gain will qualify as lower-taxed long-term capital gain.
To illustrate, let's say you use 1 Bitcoin to buy supplies for your business. On the date of the purchase, Bitcoins are worth $9,500 each. So, you have a business expense of $9,500.
But there's another part to this transaction: the gain or loss from holding the Bitcoin. You bought the Bitcoin in June 2019 for only $9,000. So, you also have a $500 gain from the appreciation in value of the Bitcoin ($9,500 - $9,000) that you exchanged for the supplies. Since you're not in the trade or business of buying and selling Bitcoin, the $500 gain is a short-term capital gain, because you held it for less than a year.
- How Are Virtual Currency Payments to Employees or Independent Contractors Taxed?
If you use virtual currency to pay employee wages, the FMV of the currency counts as wages subject to federal income tax withholding, FICA tax and FUTA tax. Like any other wages paid to employees, you must report the wages on Form W-2.
If you use virtual currency to pay an independent contractor for performing services for your business, the FMV of the currency is subject to self-employment tax for the contractor. You're required to report the payment on Form 1099-MISC if payments to that contractor during the year amount to $600 or more.
You may also have a gain or loss due to appreciation or decline in the value of the virtual currency during the time you held it before paying it out as wages or for services from an independent contractor. Because you're not in the trade or business of buying and selling virtual currencies, the gain and loss will be a capital gain or capital loss (short-term or long-term depending on how long you held the virtual currency).
- How Are Virtual Currency Receipts Reported?
If you accept virtual currency for goods or services, you need to determine the FMV of the currency on the transaction date to convert the deal into U.S. dollars. Then you can compute your taxable gain.
For example, you sell a vintage auto that you bought and restored for 3 Bitcoins. On the date of sale, Bitcoins are worth $9,900 each. Your tax basis in the vintage auto is $20,000.
How would you report this transaction on your tax return? First, you'd convert 3 Bitcoin into U.S. dollars ($9,990 × 3 = $29,700). So, your taxable gain on the sale would be $9,700 ($29,700 - $20,000).
Alternatively, Bob is an IT professional who accepts 2 Bitcoins as payment for providing services to a client. On the date of receipt, Bitcoins are worth $10,000 each. He must recognize $20,000 of taxable income ($10,000 x 2) for services rendered. Because Bob is an independent contractor, the transaction is also subject to self-employment tax.
- Need Help?
Many people are unaware of the tax rules for virtual currency transactions. But the IRS doesn't usually accept that as an excuse. Detailed records are essential for tax purposes. Your records should summarize:
- When the currency was received,
- The currency's FMV on the date you received it,
- The currency's FMV on the date you exchanged it,
- The exchange used to determine FMV, and
- Your purpose for holding the currency (business, investment or personal use).
With this information, you can figure the tax consequences of your virtual currency transactions. If you have questions or want more information, contact us to speak with one of our tax advisors.