While much has been written about the March 2014 IRS tax guidance on virtual currencies, few have done comprehensive analyses of the plethora of record-keeping and enforcement challenges that will arise as a result of the agency’s decision to treat Bitcoin as property rather than currency. Diverse stakeholders ranging from consumers, merchants, miners and Bitcoin service providers (all of whom may also be considered “investors” at various times) must now grapple with complex and unclear tax reporting requirements in the coming months – even though more clarifications and changes from the agency seem inevitable following the “public comment” period this spring.
This is the first installment in a multi-part series that takes an in-depth look at the coming tax consequences of IRS Notice 2014-21 for the U.S. Bitcoin industry.
For this installment, we’ll kick things off by outlining what Joe Consumer should discuss with his tax adviser in advance of filing his personal tax returns on April 15. For the sake of our article (and round numbers), we will assume that Joe is married and that he and his wife made a combined $100,000 of taxable income in 2013.
With that in mind, how should Joe report trading gains and losses for Bitcoin and any of his other alt-coin investments? How about purchases he made with Bitcoin?
What about the funds he lost in his trading account at the now-defunct Mt. Gox exchange – can those be written off? And how about that gift he gave to Dorian Nakamoto’s fundraiser or the tips he received for his blog posts?
We’ll attempt to tackle the basics for Joe Consumer, but the best synopsis may be this: Talk to a tax expert as soon as possible, even if you are one yourself.
Trading Gains & Losses
The most widely reported aspect of the IRS ruling on Bitcoin has to do with its treatment as property. This is a favorable ruling for most investors given Bitcoin’s stellar performance to date, as accrued long-term gains and losses will be taxed at the taxpayer’s applicable capital gains rate (15% in Joe’s case) rather than ordinary income rates (25% for Joe). For many early Bitcoin “miners” and investors, this constitutes a massive difference in marginal rates. That said, active traders who have racked up short-term capital gains may still be taxed at ordinary income rates.
Investors with trading losses, on the other hand, might not be so happy with the ruling. It will be much more difficult to write off bad Bitcoin bets now that they are considered property rather than currency. The IRS limits the amount of property losses (net capital losses, to be specific) that can be claimed on personal tax returns to $3,000 per year for both married and single filers, a limit that hasn’t been raised since 1978. For these unfortunate folks, large short-term trading losses will need to be carried forward, in some cases for many years. Trading losers would have been much better off if they could have written off “foreign currency” losses against their ordinary income.
And this is the most basic application of the IRS guidance. Buckle up folks, because the rest of this article may blow your minds, not to mention demonstrate the dire need for the IRS to conform certain areas of the tax code to the new world’s peer-to-peer structure. The full nuance of Bitcoin’s property tax treatment is complex, but let’s try to break it down piece by piece.