Since March, Bitcoin has seen a meteoric rise in price from $968 to a current price of $2,228 BTC/USD. If you were lucky enough to hold a substantial amount of Bitcoin at the time you could have seen the value of your portfolio more than double. But what is the tax ramifications of this appreciation and how can the sale of Bitcoin impact your tax liability for 2017? This blog post looks to answer these questions and give insight into the taxation of cryptocurreny.
How Is Virtual Currency Treated For Federal Tax Purposes?
For federal tax purposes, virtual currency is not treated as currency, subject to foreign currency gain or loss rules, but is instead treated as property. This means that the purchase and sale of virtual currency, like Bitcon, may be treated the same way as a purchase and sale of stocks for most taxpayers. This is great for investors who realized capital gains during this period because the capital gains rate for these transactions could be significantly less than ordinary income tax rates.
Determining Taxable Gain/Loss
The gain or loss from sale of virtual currency is determined by netting the cost basis of the virtual currency from the proceeds received at the time of sale. The cost basis in virtual currency is determined by the fair market value on the date of purchase and is subject to the same rules as property for federal tax purposes. If the virtual currency is sold for US dollars then the proceeds would be the amount of money received at the time of the sale. For example, John purchases $1,000 worth of Bitcoin in March and sells all of his holdings for $2,000 a few months later. John has a short term taxable gain of $1,000 ($2,000 proceeds – $1,000 cost basis = $1,000 gain on sale of Bitcoin).
What If a Taxpayer Uses Virtual Currency to Purchase Goods or Services?
If a taxpayer uses virtual currency to purchase goods or services then the taxpayer will have to report a gain or loss from the sale of the virtual currency with the proceeds being the fair market value of the goods or services received. So lets say John used his $2,000 worth of Bitcoin to purchase accounting services, would he still have to report a gain on the sale of his virtual currency? The short answer is yes, John would have to report a $1,000 gain regardless if he received $2,000 in cash or $2,000 in goods or services. This could be a nightmare for anyone who regularly conducts transactions using virtual currencies because they would have to keep track of both the basis of their holdings as well as the fair market value of goods and services received.
What If a Taxpayer Receives Virtual Currency For Goods or Services?
If a taxpayer receives virtual currency in exchange for goods or services then the taxpayer will treat the fair market value of the services rendered or goods sold as ordinary income. The taxpayer will also have a cost basis in the virtual currency and will report a gain or loss upon sale or transfer for goods or services. For example, if John received $1,000 worth of Bitcoin for selling $1,000 worth of financial advisory services then he will treat the $1,000 as ordinary income. John’s basis is also $1,000 and if he were to sell the Bitcoins for $2,000 then he will pick up an additional $1,000 as a gain from the sale of an investment.
LIFO, FIFO and Specific Identification
The sale of virtual currency can be treated the same way as stocks sold through trading platforms. Investors may chose to either treat the sale of a stock through the LIFO (last in first out), FIFO (first in first out) or specific identification method. However, the taxpayer must tell the broker or specifically state how they want the sale of their lots treated. For example, if John purchased Bitcoins in March, April and May but sold a portion of his holdings in June then he will have differing cost basis for each virtual currency lot. Additionally, the lot sold can have different tax basis as well as different holding periods resulting in varying tax treatments of these sales.
The treatment of virtual currency as property and not as a foreign currency has significant tax implications for investors in virtual currencies like Bitcoin. Although investors may benefit from the lower capital gains tax rate they will be limited to $3,000 in capital losses each year. Additionally, since taxpayers need to keep track of their basis and the fair market value of goods and services received it is often difficult to use virtual currency as a replacement for US dollars.