Yesterday the Internal Revenue Service (IRS) finally decided how they wanted to regulate Bitcoin in the United States, just in time for tax season!! They posted yesterday announcing that virtual currency would be taxed as property, not as currency. It does not have legal tender status.

  • Wages paid in bitcoin work pretty much the same way as cash. You get a W-2.
  • Service providers taking bitcoin have to declare it on a 1099 and self-employment rules are to be followed.
  • “The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.”  <- this part basically is capital gains law

Notice 2014-21 has a lot more detail, and an FAQ. Those details can be found here: http://www.irs.gov/pub/irs-drop/n-14-21.pdf

The Internet freaked out and a lot of bitcoiners were unsure how the new laws applied to them. Spelunk.in reached out to entrepreneur, hacker, and accountant Nick Farr for a bit more insight on capital gains taxation and how it affects Bitcoin, dogecoin, and other virtual currencies.

Spelunk.in: Can you explain how capital gains tax works to a layperson who has never had to deal with it before?

Sure. Capital gains is a tax levied on profits, (or a credit from losses) that happen when you sell assets you own. The two most common kinds among average taxpayers arise from stock investments and real estate.

If your parents bought their house in 1980 for $50,000 and sell it today for $100,000, they would owe capital gains tax on that $50,000 profit from the sale of their house.

Same thing with stocks. Say they bought a mix of tech stocks for $10,000 in 2000 and sold it today for $2,000. They could deduct that $8,000 loss from the $50,000 gain they had from the house sale.

Of course the actual tax your parents pay on the $42,000 net gain varies on a number of factors, but that’s basically how it works.

One key thing to remember is “basis”, the original purchase price of the asset. Your parent’s basis in the house is $50k. Their basis in the stock is $10k.

Spelunk.in: When you report your btc gain, what happens after that? How would a low-level daytrader expect their taxes to look like?

It’s the same thing as if they bought and sold stocks or any other kind of security. I have 500 BTC now and I know my basis in it was about $500 because I paid for that in cash. It follows that my basis is about $1 for every BTC I own.

Of course, it’s worth a lot more than that now. If I were to sell 1 BTC for $600 now, I would owe $599 in capital gains since my basis in that 1 BTC is $1.

That’s the cleanest example. It gets more complicated for miners, people who sell in bitcoin or earn it as wages or as a contractor, etc.

Spelunk.in: If you bought or mined coin when they were cheaper, you aren’t taxed until you exchange them to USD, right?

The current guidance released today treats mining differently from coin purchased for cash, no matter how it was purchased. Mined currency is taxed as income based on its fair market value when its received. However, if you mined Bitcoin before the guidance, you may be off the hook for the income component, but you’ll owe capital gains once you buy something with coin or exchange it for cash.

Spelunk.in: What if you stored those coins, and every purchase you wanted to make, you had bought new coins to offset your purchase (effectively leaving your stored coins alone). This could be true of people using paper wallets. How would a person know what the value of the btc they’re spending when they bought at drastically different amounts and stored in a variety of ways?

This is the same basis calculation problem one faces when selling stock. A friend of mine got 10 shares of Apple stock as a high school graduation present from one of their relatives who was an employee there. They got 100 when they graduated from college. They went on to work for Apple, vested and through exercising options ended up accumulating something like 4200 shares which they sold to buy a house.

Figuring out their basis took me two days of tracking down brokerage statements, options agreements, old returns and historical stock prices.

Fortunately, we have the blockchain to look at. Given that, as long as people remember which wallets are theirs, they could probably write up a script that compares the blockchain to the relevant cash prices at the time of each transaction and calculate their basis, gains and losses relatively easily.

The critical thing to remember is that the IRS is looking at transactions as they’re received. Paper wallets is an interesting case… but it’s similar to keeping track of cash. In small amounts for the average person, it’s negligible. If you bought less than say $500 in bitcoin and spent it like cash on goods and services with a fair market value, there’s hardly a capital gains worth reporting.

I go to Europe 3x a year and I don’t report the gains or losses associated with the few hundred Euros I keep in cash–because that is cash I intend to spend not invest or profit from.

Spelunkin: Some may have already filed taxes for 2013, but the last question in the FAQ makes it sound like the taxpayer is liable for gains or losses that may have happened previously. Some early adopters may have held bitcoin up to 4 years ago, and wouldn’t have likely filed. What’s the best course of action for them?

One critical thing in the IRS guidance that everyone seems to have missed is declaring income from Bitcoin you earn for services rendered or as an employee.

If you’re paying employees in Bitcoin, you’re still liable for paying the relevant employment taxes and reporting the USD equivalent of that employee’s earnings to them on a W-2. There are a lot of people who pay their employees and contractors in Bitcoin, and the same reporting and withholding rules apply.  Employment tax constitutes the bulk of the IRS’s enforcement efforts and I suspect employers using Bitcoin for payment are the first Bitcoin users the IRS will start going after.