Taxation of Convertible Virtual Currency, Part I: It’s Not Money & Part II: Taxation of Virtual Currency Income

Liz Prehn for Moskowitz, LLP writes: Taxation of Convertible Virtual Currency, Part I: It’s Not Money

Ecuador will soon be the first country in the world to have digital currency issued by a central bank. Although the new Ecuadorian currency won’t necessarily function like Bitcoin, Litcoin, Peercoin and Freicoin, or other common alternative currencies in the virtual marketplace, the increasing use of virtual currency worldwide is a trend that can no longer be ignored.

Many countries are beginning to clarify the tax treatment of virtual currency; this past March, the IRS released guidance in Notice 2014-21 on how transactions using convertible virtual currency will be taxed in the U.S.  Note that this guidance only applies to “convertible virtual currency,” that is, virtual currency that “has an equivalent value in real currency” or that “acts as a substitute for real currency.” This means that it can be traded digitally and either purchased by or exchanged to U.S. dollars or other real currencies.

Calculating gain or loss of convertible virtual currency

Borrowing the FinCEN definition of virtual currencies, the IRS decided not to treat these currencies like money, since they are not legal tender. The IRS opted instead to treat them like property with a basis and a fair market value, subject to capital gains and losses:

• The basis of convertible currency is its fair market value on the date it was received, measured in U.S. dollars.
• The fair market value of virtual currency is determined by converting the virtual currency into U.S. dollars or any other currency which can be converted into U.S. dollars in any manner that is reasonably and consistently applied.
• Calculating capital gains and losses in convertible currency is done in the same manner as calculating gains and losses in the buying and selling of stock—there is a taxable gain if the fair market value at the virtual currency’s sale exceeds the taxpayer’s adjusted basis; there is a capital loss if the value is less at sale than at receipt. 
• If the sale or exchange involves virtual currency that was treated by the taxpayer as a capital asset, such as stocks, bonds and other investment property, it is realized as a capital gain or loss. 
• If the virtual currency was treated like inventory or other property held mainly for sale to customers in the taxpayer’s trade or business, it is not considered a capital asset and the taxpayer realizes ordinary gain or loss.

Tracking your basis and sale value

Tracking basis and value at sale is fairly straightforward for taxpayers dealing in convertible currency as an investment. For taxpayers who treat it like cash, it may be difficult to determine the basis and the holding period.

Part II of this series will focus on convertible virtual currency income from wages, self-employment income and mining activities.

Part II: Taxation of Virtual Currency Income

In Part I of this series, we discussed the IRS guidelines on the taxation of gains and losses associated with convertible virtual currency.  In this post, we will focus on the taxation of income--wages, self-employment income and income from the “mining” of virtual currency.

Virtual currency income

James Howells of the UK began “mining” Bitcoins in 2009, when the pastime of creating virtual currency by having your computer solve mathematic problems was done exclusively by tech geeks and the value was minimal.  A few years later, Howells cleaned house and threw away an old computer with a digital store of 7,500 Bitcoins. In November of 2013, he realized that those Bitcoins were worth $7.5 million.  With no backup, the only way of retrieving the Bitcoins was to go through25,000 cubic meters of waste and earth at the nearby landfill-an obviously hopeless task.

A growing number of taxpayers are now earning in Bitcoins and other convertible virtual currency, and IRS Notice 2014-21 provides guidelines on how this income is treated for income tax purposes.  In sum, income in the form of convertible virtual currency is treated no differently than income received in more traditional ways:

• Wages.  Employees paid in virtual currency must pay taxes on their earnings, at the fair market value on the date of payment. This income is subject to federal income tax withholding and payroll taxes. The wages must be reported by the taxpayer’s employer on Form W-2.
• Self-Employment Income. Virtual currency received for services performed as an independent contractor are subject to the self-employment tax.  This self-employment tax is imposed on the fair market value of the income as of the date of receipt (measured in U.S. dollars). Payers must issue a Form 1099 to the taxpayer for the annual payment of more than six hundred dollars when the payment is incurred as an ordinary and necessary expense of the payor's business.
• "Mining" Virtual Currency. If a taxpayer generates new Bitcoins or other convertible virtual currency, the fair market value of that virtual currency on the date of receipt is includible in the taxpayer’s gross income. If the taxpayer mines virtual currency as their trade or business, and the taxpayer is not mining as an employee, the taxpayer’s gross income from mining (less allowable deductions) is considered self-employment income and is subject to self-employment tax.

Look to the not so distant future:

San Francisco’s first Bitcoin Teller Machine (BTM) was just installed this past September at the Workshop Cafe on Montgomery Street.  Right in office our  building!   The BTM allows users to convert their Bitcoins to cash (and get a great cup of coffee in the process).  We will be keeping a close eye on how the new tax guidance affects the Bitcoin and other convertible virtual currency markets, and whether Bitcoin will proceed to develop as a form of “currency” for ordinary transactions. In the meantime, keep track of your virtual currency--and please don’t throw it out.