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.
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.
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.