Kevin Bergesen for Holland & Knight writes: June 30 is the deadline for taxpayers with a connection to
foreign financial accounts to file FinCEN Form 114, Report of
Foreign Bank and Financial Accounts (FBAR). As this is the
first year in which all
FBARs must be electronically filed, the IRS, which conducted a
webinar on June 4, spent a great deal of time discussing the
e-filing requirements. (Please see
PowerPoint presentation.)
During the webinar, Rod Lundquist, a senior program analyst for
the Small Business/Self-Employed Division at the IRS, indicated
that bitcoin do not need to be reported on the FBAR.
Lundquist was quoted by Bloomberg BNA as
saying, "At this time, FinCEN has said bitcoin is not
reportable on the FBAR, at least for this filing
season."
While this is likely welcome news for taxpayers who own bitcoin, the IRS also recently provided taxpayers with much needed clarification as to their taxability. On March 25, 2014, in Notice 2014-21 (the "Notice"), the IRS released guidance explaining that bitcoin would be treated as "property" and not as "currency" for federal income tax purposes. The notice clarifies that taxpayers must maintain records of their basis in bitcoin at the time of acquisition and must track and report any gains realized upon the sale or other disposition of bitcoin as taxable income.
While this is likely welcome news for taxpayers who own bitcoin, the IRS also recently provided taxpayers with much needed clarification as to their taxability. On March 25, 2014, in Notice 2014-21 (the "Notice"), the IRS released guidance explaining that bitcoin would be treated as "property" and not as "currency" for federal income tax purposes. The notice clarifies that taxpayers must maintain records of their basis in bitcoin at the time of acquisition and must track and report any gains realized upon the sale or other disposition of bitcoin as taxable income.
What is bitcoin?
To the extent it can be defined simply, bitcoin is a form of
currency that exists in a limited supply and can be stored
digitally and transferred directly to any other computer (or
compatible phone, tablet, etc.) without passing through a
centralized financial institution. Bitcoin is not backed by any
centralized bank or any physical commodity.
The Notice describes bitcoin as "[a] digital representation
of value that functions as a medium of exchange, a unit of account,
and/or a store of value." Because bitcoin has a monetary value
in "real" currency, and can act as a substitute for
"real" currency, bitcoin is further classified as
"convertible" virtual currency.
Bitcoin is Not Currency
The Notice clearly states that for U.S. federal income tax
purposes, the IRS will not treat bitcoin as currency, but rather as
property, and will apply existing tax principles to determine the
timing and character of income, gain, or loss, in the same manner
as these principles are applied to the sale or exchange of
securities or other property.
This means that gains and losses on the disposition of bitcoin
will not be treated as "exchange gain or loss" and will
not be ordinary in character. This is bad news for investors who
hold depreciated bitcoin and were hoping to take exchange losses as
ordinary losses, but is good news for investors who hold
appreciated bitcoin and hope to take advantage of capital gains
treatment.
For those individuals holding bitcoin for sale in a regular
trade or business ("miners" and "dealers"),
income resulting from the sale of such bitcoin will be taxed as
ordinary income. However, for most investors who merely
"trade" in Bitcoin, gains or losses will be capital and
not ordinary.
Increased Burdens on Taxpayers
The Notice states that taxpayers who invest in bitcoin are
obligated to report capital gains or losses upon the sale or other
disposition of these assets. The burden on the taxpayer is twofold:
he or she must (i) maintain a record of his or her basis in the
bitcoin, and (ii) determine the fair market value of the bitcoin at
the time they seek to sell or otherwise dispose of it.
The second prong is reasonably straightforward. The amount
realized at the time of disposition is equal to the U.S. dollar
value of the assets received in exchange for the bitcoin. The fair
market value must be determined by reference to the bitcoin/U.S.
Dollar price quoted in an online exchange. Unfortunately, there is
no official exchange, and considerable inconsistency exists among
exchanges. The Notice provides little guidance except to state that
the bitcoin to U.S. dollar conversion must be made "in a
reasonable manner that is consistently applied."
The first prong is far murkier and will likely cause headaches
for the average person seeking only to hold bitcoin as an
investment or use bitcoin to pay for goods or services. If a
taxpayer does not maintain separate accounts (known as virtual
wallets) for each of his or her bitcoin having a different basis,
it will be difficult to properly identify basis upon a partial
disposition from the virtual wallet. The IRS would likely respect
"First In First Out" or a similar methodology, but has
not yet provided any guidance on this issue. Until a universal
methodology is adopted, taxpayers with mixed-basis virtual wallets
should maintain detailed basis records in order to defend against
any accusations that they are committing fraud by shifting basis
within a virtual wallet or deceitfully selecting high-basis
currency for sale.
Penalties for Noncompliance?
The tax treatment described in the Notice has full retroactive
effect, and thus penalties may be due for those taxpayers who have
taken positions inconsistent with the Notice on their previously
filed returns, including underpayments attributable to bitcoin or
failure to timely or correctly report bitcoin transactions.
Further, the IRS has given no indication that it will show any
leniency and has cited that the generally applied reasonable cause
standard should apply to any taxpayers seeking abatement of
penalties. Taxpayers who sold bitcoin in recent years should amend
these returns if bitcoin income was not properly disclosed.
Legislative Response
In response to the Notice, Texas Congressman Steve Stockman
proposed H.R. 4602, The Virtual
Currency Tax Reform Act, aimed at authorizing the IRS to treat
virtual currencies as currency rather than property. Because
current law allows U.S. taxpayers to ignore de-minimus gains and
losses in foreign currencies, this treatment would eliminate the
basis-tracking and reporting burdens for the vast majority of
bitcoin investors.
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