Remember this is by some person, don't live and die by this, but I am now more confused than anything. I understand cryptographics and how smart contracts work but this tax code is like reading hieroglyphics.
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Introduction
I've noticed a significant amount of uncertainty around here about the taxation of bitcoins. In effort to provide some guidance , I've compiled some of the most common questions I've seen and tried to provide straight-forward, easy to understand answers. I am a tax attorney, but there is so much uncertainty surrounding bitcoins that I expect some people to disagree with one or more of my conclusions. If you have a contradictory opinion, please share it. We would all benefit from an educated discussion of this issue.
Keep in mind this post is intended for a layman audience. If you are a tax professional or want a detailed examination of this topic, you find this post lacking. Please don't nit pick this post with technicalities or narrow exceptions, I purposely excluded such nuances for the sake of readability.
I should note that this post does not address aggressive tax planning strategies. Such strategies are a lot of fun to discuss, but they do not belong in this type of post. If you are interested in such strategies, perhaps we can make a follow-up post on another day.
Legal Disclaimer
This post was created for general guidance on matters of interest only, and does not constitute legal advice. You should not act upon the information contained in this publication without obtaining specific advice from a tax professional. No representation or warranty (expressed or implied) is given as to the accuracy or completeness of the information contained in this post, and I do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this post or for any decision based on it.
CIRCULAR 230 DISCLOSURE To ensure compliance with requirements imposed by the IRS, I inform you that any U.S. federal tax advice in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
Topic 1: Realization
#1: Are gains on Bitcoins taxable?
Yes. This is one of the only unequivocal answers you'll find in this post. Under the Internal Revenue Code, all income is taxable, regardless of source or form. Bitcoins present a lot of interesting tax questions, but whether gains are taxable is not one of them.
#2: When do my gains become taxable?
Your gains are taxable in the year that they are realized. Realization occurs when you exchange bitcoins for any type of other property; such as cash, merchandise, or services. This includes everything from haircuts to yachts. Essentially, any transaction involving the exchange or sale of bitcoins is a realization event and triggers taxable gain.
Because I've seen a lot of misinformation on this point, I want to make myself perfectly clear. If you own bitcoins that have appreciated in value, you cannot use them to purchase a goods or services tax free. Such a purchase is an ascension to wealth, and is therefore taxable. This is no different than if you had sold the bitcoins for cash and used the proceeds to purchase the goods or services directly. Yet, one would be taxable while the other would not? The IRS would never tolerate such a blatant loophole, and neither would the courts. In fact, we already have a long line of IRS rulings and Supreme Court cases rejecting identical arguments made for other types of assets. The outcome for bitcoins will be the same.
Unfortunately, this has some serious implications for the future of bitcoin. I have to question the effectiveness of bitcoin as a medium of exchange when the user has to calculate his or her tax liability on every single transaction. As the saying goes, the power to tax is the power to destroy, and this is no exception.
Note: there is a code section that might provide some relief here, but only if bitcoins are categorized as a foreign currency. Under this code section, the use of bitcoin to buy goods and services would be tax free as long as the transaction was personal (i.e. not for business or investment) and did not generate more than $200 of gain.
#3: What if I sell my bitcoins but do not withdraw the proceeds from the exchange?
It doesn't matter, your gains were realized the moment you sold them. It is irrelevant whether the proceeds from the sale are kept in your bank account or your exchange account, you still have a realized gain for tax purposes.
#4: What if I exchange my bitcoins for altcoins?
This is a fair question and implicates what is known as a "like kind exchange." Like kind exchanges do not trigger realization, and therefore are tax-free. Although it's technically possible for bitcoins and altcoins to qualify for-like kind treatment, I think it's exceedingly unlikely. The regulations for like kind exchanges require the two property types to have the same rights, characteristics, and obligations. Whether altcoins and bitcoins meet this test is uncertain, but I would tend to think not. Additionally, if characterized as a foreign currency, bitcoins would be automatically barred from like-kind treatment anyways. Thus, there are two significant legal hurdles that must be overcome before bitcoin and altcoins can qualify as for like-kind status. Although nothing is for certain when it comes to bitcoins, I'm fairly confident that like-kind treatment will fail at one or both of these hurdles. Thus, I would not suggest that you try to qualify such a transaction as a like kind exchange until further guidance on this issue is given by the IRS.
#5: So how can I avoid realizing gains on my bitcoins?
The only way to avoid realization is to hold your bitcoins without selling or exchanging them. If you were hoping for a different answer, I'm sorry. Whether you decide to actually report you realized gains is of course a different matter, but as far as the law is concerned, you have realized gains upon any sale or exchange of your bitcoins.
#6: How does the IRS know about my gains?
The IRS only knows what they are told. This means that they have no knowledge of your bitcoin transactions unless someone tells them. There are four ways this can happen.
First, bitcoin exchanges or payment processors may report your transactions to the IRS by filing a form 1099. However, these businesses do not appear to be subject to the 1099 requirements (although that will probably change), and its unlikely they would voluntarily do so. So for now, this is probably won't happen. Keep in mind that the exchange or payment processor will need your social security number to file a Form 1099.
Second, your bank may file a Suspicious Activity Report ("SAR"), which could trigger an investigation for money laundering and tax evasion. Banks are required to file SARs for suspicious wire transfers that are greater than $5,000. Most banks are overly cautious and automatically treat any large international transfer as suspicious. So, if you transfer large amounts of money to/from an international exchange, its likely your bank will file a SAR. This doesn't mean that you are automatically flagged for investigation, but it puts you on the radar. The larger and/or more frequent your transfer(s), the more likely it will become a legitimate red flag that could lead to an investigation. Keep in mind that your bank is prohibited from telling you whether or not they filed a SAR against you.
Third, someone can rat you out to the IRS, which happens far more often than you might think. The simple fact is that people get jealous, and if they've heard that you've made lots of tax free money on bitcoins, they might get tempted to make sure justice is served. There's also that nice reward the IRS will pay them based on how much money the IRS ultimately recovers from you.
Fourth, you voluntarily and accurately report your gains on your tax return. That might sound ridiculous to some people given the inherent anonymity of bitcoin, but there are some very rich people in prison right now who used to think the same thing about their Swiss bank accounts. The fact is that penalties for failing to report income are significant. This includes the possibility of criminal prosecution. You can also add to this the additional penalties for failing to report foreign financial accounts (discussed below), which can be even more severe.
At the end of the day, you have a decision to make. You can comply with the law and pay taxes just like everyone else, which although annoying, is really not that big of a deal. Alternatively, you can violate the law and hope that you don't get caught. Maybe you will, maybe you won't. If you are caught, though, the amount of money you'll be forced to pay in penalties and interest will drastically exceed the amount you saved. That's not to mention the possibility of a felony criminal conviction and all the negative consequences that accompany it (including a prolonged stay at Club Fed). Personally, I have seen the havoc wreaked on people's lives by tax crimes and I would never want to be in their shoes. Neither should you.
Topic 2: Recognition
#7: How do I calculate my gain or loss?
Gain or loss is calculated first on each bitcoin transaction, then on a an aggregate basis for the year. Basically, gain or loss is computed by taking the sales price of each bitcoin and subtracting it's cost. The technical terms are amount realized and basis. Although simple in concept, determining amount realized and basis can be quite complex (see below for more information).
Your tax preparation software will automatically perform these calculations, so the actual mechanics aren't really necessary for you to understand. However, you'll have to know the basics in order to enter the correct information into the software.
#8: What is my Basis?
Generally, basis is equal to cost. So, if you purchase 1 BTC for $500, then your basis is $500. You can also add to this amount any acquisition costs like broker commissions or wire transfer fees. So, let's assume a 1% fee and a $5 wire transfer fee. This would mean your basis is $500 + $50 + $5 = $555.00. If you later sell that bitcoin for $900, your gain would be [$900] - [$555] = [$365].
#9: How do I determine my basis in each bitcoin?
If you own bitcoins that were purchased at different times and at different prices, determining basis can be quite complex. This is because bitcoins are fungible. Once a bitcoin is purchased, it becomes indistinguishable from your other bitcoins stored in the same wallet or account. In a subsequent sale or exchange, there is no way to identify the bitcoin being transferred out, and therefore you cannot accurately determine its cost or acquisition date.
Contrary to what you might have heard, you cannot just guess it's cost or arbitrarily choose the one that gives you the lowest tax liability. The IRS requires you to use a system with rules that will produce a reasonable and consistent result. As long as you use it year-to-year and the chosen method does not always give you the highest basis available, the IRS will probably respect it.
The default system (and the one generally preferred by the IRS) is to assume that your bitcoins are sold in the order they were acquired. Thus, the first bitcoin you purchase is assumed to be first bitcoin you sell. This is called the FIFO method ("First in, First Out"). There are some other methods available, such as LIFO ("Last In, First Out") and Average Cost Basis, but I would caution against using any system other than FIFO until additional guidance on this issue is provided by the IRS.
I'll note that it's theoretically possible to avoid this problem altogether if you keep each and every bitcoin purchase in separate wallets or accounts. This would allow you to trace the actual cost of each bitcoin you later sell or exchange, alleviating the need for the FIFO (or alternative) method.
Either way, determining cost will require some detailed record keeping. I will discuss record keeping in more detail below, but remember that the burden to prove basis is on you. The IRS will not give you the benefit of the doubt here. If you cannot prove the cost of each bitcoin, they will assume it was $0. Obviously you don't want that to happen, so keep good records of your bitcoin purchases.
#10: What if I mined my bitcoins, what is my basis then?
This is a very difficult question to answer with any degree of certainty. The problem is that bitcoin mining is a completely unique activity that yields an even more unique product. To reach an answer, one must resolve some difficult tax issues. Namely, what is bitcoin mining and how do we classify the bitcoins it produces?
Unfortunately, addressing these two issues would be a lengthy and detailed post in itself, so I cannot fully address them here. Suffice it to say that bitcoin miners will need a very competent tax advisor to make sure their gains are properly reported.
Not to leave you without any guidance whatsoever, the answer will most likely depend on the size and scope of your mining activity. Large scale miners should probably treat themselves as a manufacturing business, and the bitcoins they produce as inventory held for sale to customers. Such bitcoin miners would not determine their gains in the same manner as normal investors. They would compute income at the end of the year by figuring their total sales and then subtracting "cost of goods sold." The latter would take into account the cost of producing bitcoins, such as electricity. Other expenses, like depreciation on the mining rig, would presumably be deductible as an ordinary business expenses. Obviously this implicates some complex accounting rules that are far beyond this post. A tax advisor with some knowledge of these rules would be needed to accurately determine your tax liability.
Smaller mining operations can probably get away with treating their mining as an "activity for the production of income," as opposed to a manufacturing business. In such a case, they would follow the same rules for determining gain or loss as normal rules investors. I suspect their basis in this case would be determined by allocating their mining costs on a pro rata basis, assuming they can reasonably track and allocate such expenses (such as electricity). The safest and most conservative approach, on the other hand, would be to use a basis of zero. Depreciation and other indirect expenses would likely be deductible as an itemized expense, similar to a general investor (see below).
I must emphasize that neither of these treatments is a perfect fit. I expect different tax advisors to reach different conclusions on the correct treatment. The goal in any case is to use the best method of matching income to expenses, whatever that is. Presumably the IRS will respect your chosen method as long as you can convincingly argue that it is the best at accomplishing this goal.
#11: What if I received my bitcoins as payment, what is my basis then?
If you sell goods or services and accept bitcoin as payment, your basis in those bitcoins is equal their fair market value at the time they were received. Generally, this is determined by reference to the average market price on that day. Thus, if you wrote a software program for someone and received 1 BTC as payment on November 1st, your basis in those bitcoins is equal to the average price of 1 BTC on that day.
The choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
#12: How do I determine Amount Realized (i.e. Sales Price)?
This depends on the transaction and if you sold bitcoins for cash or exchanged them for goods/services.
In the case of a sale, amount realized is equal to sales price, less any selling costs you incur in the transaction (like commissions or wire transfer fees). So, if you sell a bitcoin for $900 and incur a 1% transaction fee, your amount realized is $900 - $9 = $891.00.
If you exchanged bitcoins for goods or services (instead of selling them), then amount realized is more complicated. This is essentially a barter transaction, where the default rule is to use the fair market value of the goods or services received in the exchange. For example, if you purchased a laptop on November 29th with bitcoins, your amount realized would be equal to the Fair Market Value of the laptop on that date. The easiest way to determine Fair Market Value is by reference to the sales price, although an alternative method can be used if yields a more accurate value.
Presumably, the sales price of most goods or services will be denominated in dollars (even though payment is made in bitcoin). Thus, if the laptop's price was $1,500, you can safely assume that it's FMV was also $1,500. If the sales price is denominated in bitcoin (instead of dollars), you'll have to convert it into dollars using the average exchange price on that day. As mentioned above, the choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. The most conservative option would be to use the price from the exchange that you purchased the bitcoin in the first place. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
Topic 3 Character
#13: Are my gains "capital gains?" Probably. The first hurdle to clear is the classification of bitcoins as a capital asset, because capital gains treatment applies only to capital assets. This is actually a pretty easy hurdle to clear because the definition of a capital asset includes all forms of property by default, unless specifically excluded. So, if you look at the list of excluded property under § 1221(a) of the code, you'll see that bitcoins are not excluded by name, nor would they fall within any of the excluded categories. (keep in mind that this is not true if bitcoins are held as inventory in a trade or business, which might be the case if you mine bitcoins, nor is it true if bitcoins are classified as a self-created intangible asset like a copyright or artistic composition, which is unlikely but possible).
Thus, bitcoins are a capital asset in the hands of most taxpayers and qualify for capital gains treatment. If you were lucky enough to buy your bitcoins more than a year ago, then your gains would qualify for the lower preferential tax rate given to long term capital gains (probably 15%, but it depends on your income level).
If you held you bitcoins for one year or less, then the gains are characterized as short term capital gains, which are taxed at ordinary income tax rates (i.e. the same rate as your paycheck).
Note that a different characterization would apply if bitcoins are treated as a foreign currency. Whether bitcoins will be so treated is uncertain, but if you're curious, read the answer below.
#14: What if I mined my bitcoins?
As mentioned above, the tax treatment of bitcoin miners is very uncertain. The primary question here is whether you are engaged in a trade or business, and if so, if your bitcoins should be classified as "inventory." If the answer to both of these questions is "yes," then your bitcoins are not capital assets and your gains are taxable as ordinary income. If the answer to either of these questions is "no," then your gains are taxable just like a normal investor (i.e. as capital gains).
Unfortunately, there is no clear answer to these questions. For some bitcoin miners the answer will be yes, for others it might be no. The tax treatment will depend on the specific facts and circumstances of your case, although the bigger your mining operation, the more likely it should be treated as a trade or business (and therefore taxed at ordinary rates). I suggest consulting with a competent tax advisor to determine whether your mining activities rise to that level.
#15: What if I'm a "day trader?"
Generally, the tax treatment for day traders is the same as a regular investor. Of course there are exceptions to this rule, such as the mark-to-market regime, but they would not apply to bitcoins without some affirmative directive by the IRS.
There is also the possibility of your day-trading activities rising to the level of an actual business (which would make your gains and losses "ordinary.") The IRS is extremely stingy when it comes to classifying day-traders in this manner, though, so it's unlikely you have anything to worry about here. However, you should consult with a tax advisor to be sure about your status.
#16: What if Bitcoins are classified as a collectible?
As a collectible, the gains would still be "capital gains," but the lower tax rate given to long term capital gains would be fixed at 28% (instead of the 15% most taxpayers would use). However, it's pretty unlikely at this point that bitcoins would be classified as a collectible. First, bitcoins are not specifically named in the code section that defines "collectibles." Second, collectibles are traditionally limited to tangible assets, whereas bitcoins are intangible assets. (Note: there might be an argument that physical bitcoins, such as those made by Casacius, are "collectibles." However, that would still require some declaration by the IRS or Congres to make certain). Thus, for now, it's safe to conclude that bitcoins are not a collectible and regular long-term capital gains treatment applies.
#17: What if bitcoins are treated as a foreign currency?
As a foreign currency, bitcoins would be disqualified from capital gains treatment (even though still technically a capital asset). In other words, all bitcoin gains would be taxable at ordinary income tax rates regardless of holding period. Although this sounds like bad news for bitcoin investors, there are some caveats that arguably outweigh the negatives of this outcome .
The biggest is the exception under the foreign currency rules for "personal transactions." Under this exception, gains of less than $200 are tax free as long as the transaction is not for investment or business purposes. Remember that without this exception, every exchange of bitcoins for goods or services would trigger taxable gain, which creates a significant burden on the use of bitcoin for day-to-day transactions. Thus, this exception is a potential game changer for the future of bitcoin. Assuming that most consumer transactions would generate less than $200 of gain, there would be no tax consequences to the use of bitcoin for personal spending. The implications of this outcome cannot be overstated.
If the gains are greater than $200 (on personal transactions), they are no longer tax free. However, instead of being taxed as ordinary income, the code allows them to be treated as capital gains instead. Thus, the gains would be eligible for the lower tax rate given to long-term capital gains . Although not as significant as the $200 exemption mentioned above, this still offers a benefit to consumers who use bitcoin for day-to-day personal transactions.
Just to be clear, any gains on non-personal transactions would be ordinary income. So, investors would lose the lower tax rate given to long-term capital gains. However, this isn't as bad as it sounds. First, many investors - particularly day traders - do not hold bitcoin for longer than one-year anyways, so their tax rate is effectively unchanged. Second, because they are no longer "capital," bitcoin losses would be fully deductible (i.e. not subject to the $3,000 limitation discussed below). Finally, investors stand to benefit indirectly from the $200 exemption mentioned above. That is because this exemption should help propel the wide spread use of bitcoin, is likely to be the greatest catalyst for future market appreciation.
#18: So, are bitcoins foreign currency?
It is impossible to say at this point whether bitcoins are a foreign currency for purposes of income taxation. No US court has directly addressed this issue, nor has the IRS published any guidance . The closest we've come is an obscure federal court decision written by a Magistrate judge involving bank fraud chargers (which has nothing to do with taxation) and a ruling by FinCen that bitcoin is not a currency. However, the FinCen ruling uses an extremely narrow definition of currency that has no application whatsoever to the issue of taxation.
Thus, bitcoin users and tax professionals are left to guess as to it's proper classification. The conservative approach is to treat bitcoin as a normal capital asset until some further guidance is issued by the IRS. This is consistent with the general attitude towards bitcoin expressed by the IRS, as well as some notable legal scholarship on the issue. When dealing with uncertainties such as this, it is generally advisable to proceed with the most cautious option available, which would be treating bitcoin as a capital asset (not a foreign currency).
This is not to say that you would be without a basis for treating bitcoin as a foreign currency. Indeed, bitcoins are intended to serve as a medium exchange and lack any other functional purpose. Unlike gold, silver or other commodities that have served as currency in the past, bitcoins do not have any industrial or commercial usefulness aside from exchange. This arguably makes them much more similar to a currency than a commodity or other capital asset.
Of course, the fact that bitcoins are not minted by any foreign government or bank casts some doubt as to whether they are truly foreign. However, the internal revenue code does not employ the term foreign currency. It distinguishes currency as being functional or nonfunctional. Further, it declares that only the US dollar can be a functional currency. Thus, the fact that bitcoin is not produced by a foreign government is not actually relevant, because any currency that is not the US dollar is automatically a non-functional currency and therefore subject to the foreign currency rules.
In the end, the decision of whether to treat bitcoins as a foreign currency is up to you (and your tax advisor). The trouble is that the IRS could subsequently try to undo your elected treatment and assess the additional tax that would result. Of course, it's possible that the IRS will ultimately agree with your treatment of bitcoin as a foreign currency, in which case you would not be at any risk by adopting the treatment early. I wish I could provide a more concrete recommendation here, but at this point it's just too uncertain.
Topic 4: Deductions
#19: What kind of expenses can I deduct as an investor?
You are permitted to deduct expenses for the production of income on your tax return as an "itemized deduction." However, this deduction is fairly meaningless for most investors. This is because you must actually itemize your deductions instead of taking the standard deduction, which many taxpayers do not. Additionally, such expenses fall within the category of "miscellaneous itemized deduction," which are only deductible to the extent they exceed 2% of your Adjusted Gross Income. The 2% floor is particularly troublesome because most investment expenses are pretty insignificant. Recall that you've already accounted for commissions and wire transfer fees in determining "amount realized" and "basis." Your remaining expenses might include:
• Investment interest (limited to the amount of your net gains), • Rent expense for a safety deposit box (this could arguably be extended to include the cost USB drives for cold storage), • Consulting fees for the tax treatment of bitcoin, • Depreciation on equipment used in the production of income, such as your computer (however, you'll have to allocate the cost of the equipment between personal use and investment use, which is likely to reduce this deduction substantially in most cases).
In most cases, these deductions will be quite small. Other expenses may or may not be available to you, depending on your specific situation, though. You should consult with your tax advisor to be certain of your deductible expenses.
#20: What kind of expenses can I deduct as a miner?
If your mining operation is substantial and continuous enough to be considered an actual business, then you can deduct all of your ordinary and necessary expenses. This would include the cost of electricity and depreciation on your mining rig, among others. If your mining operation is not substantial or continuous, you would deduct expenses like an ordinary investor.
As mentioned above, the tax treatment of bitcoin miners is exceptionally uncertain. So, its important that you obtain the advice of a tax professional with regards to whether or not your activity rises to the level of a trade or business.
Topic 5: Record Keeping
#21: What kinds of records should I keep? You are required to maintain records sufficient for determining the amount of your gain or loss, as well as the holding period of your bitcoins. This is a flexible standard and depends on the circumstances. Ideally, you should maintain a log of all your bitcoin acquisitions and dispositions, including the price, date, and related address of each transaction. Many exchanges make this information available to you in the form of a downloadable spreadsheet.
#22: How long should I keep my records?
The IRS can generally go back and audit your tax returns for a period of 3 years. However, they can go back 6 years in some cases. Thus, the safest answer is to save records for 6 years (determined from the date you filed you tax return).
#23: What if I don't maintain records?
You are required by law to maintain records, so failing to do so will result in the assessment of civil penalties against you in a subsequent audit. Penalties aside, it is in your best interest to maintain records because the burden is on you to prove your basis. Thus, if you cannot reasonably establish your purchase price, the IRS will assume it is zero. The same goes for holding period (which would cause you to lose the benefit of the lower long term capital gains rate).
This assumption can be disastrous if you engage in a lot of bitcoin transactions. For example, imagine a day trader who buys $2,000 worth of bitcoins after seeing a specific market signal, which he then sells shortly after for a small profit of $100. He does this only once per day. If he is subsequently audited and lacks the necessary documentation to prove his basis, the IRS will assume it was zero. Thus, he would be taxable on $2,100 of gain every day, instead of just $100. That is a total taxable gain of $766,500 for the year, compared to $36,500if he had kept adequate records.
Topic 4: Foreign account reporting
The requirements to report foreign accounts are complex and convoluted, such that many taxpayers and tax preparers overlook them entirely. However, the penalties for doing so are severe - even criminal in some cases. Therefore, I feel compelled to address the reporting requirements for foreign accounts even though I rarely see any questions on this issue.
#24: What are the foreign account reporting requirements?
There are two separate reporting requirements under federal law, each created by a different statute (The Bank Secrecy Act and the Foreign Account Tax Compliance Act). Although the exact wording is different between the two statutes, they generally require reporting of financial accounts held at foreign financial institutions. Whether bitcoin wallets and exchange accounts fall meet the definitions for these terms is debatable.
#25: Are paper wallets subject to the foreign account reporting requirements?
Probably not. The reporting requirements generally apply to financial accounts held at foreign financial institutions. It's pretty difficult to imagine that a paper wallet containing your bitcoins would satisfy this test. However, it's believable that the IRS will seek a change to this rule sometime in the future. For now, though, it's safe to assume that paper wallets are not subject to the reporting requirements.
#26: Are electronic wallets and accounts at a foreign bitcoin exchange (such as Mt. Gox or BTC-e) subject to the requirements?
Yes, although there's room for disagreement here. The answer depends on whether electronic wallet providers and bitcoin exchanges are "foreign financial institutions," and whether an account with one of these exchange is indeed a "financial account."
Unfortunately, an analysis of these definitions and the myriad of exceptions that apply is too large of a task for this post. However, because foreign exchange accounts accept deposits of fiat and provide brokerage services, it's hard to argue that they are not subject to one or both of the foreign financial reporting requirements. The case against reporting electronic wallets is slightly stronger, but is still quite weak in my opinion. I would recommend that bitcoin holders err on the side of caution and report such accounts (subject to the minimum balance requirements discussed below) until further guidance is provided by the IRS. As you'll see below, the penalties for failure to file are tremendous and not worth the risk.
#27: What is the minimum account balance for reporting the reporting requirements?
The first threshold is provided by the Bank Secrecy Act and is $10,000.00. The test if whether the total aggregate value of your foreign accounts exceeds $10,000.00 at any point during the year. If so, you must report the highest balance for each account during the year by filing an FBAR with the IRS. This form is filed separate from your income tax return and must be received by June 30th of each year.
The second threshold is provided by the Foreign Account Tax Compliance Act (FACTA). The test is whether the aggregate value of your accounts exceeds $50,000.00 on the last day of the year, or exceeds $75,000 at any point during the year (for unmarried filers). If so, then you must report the highest balance of each account during the year by filing Form 8938 with your income tax return. Note: this is in addition to the FBAR filing.
#28: What is the penalty for failing to file an FBAR? The penalty for failure to file an FBAR under the BSA varies depending on "willfulness." If your failure to file was not willful, the penalty is capped $10,000. If your failure was willful, the penalty is the greater of $100,000 or 50% of the highest account balance for each account. Criminal penalties can also apply.
Willfulness is defined generally as the intentional disregard of a known legal duty. The IRS will typically asserts willfulness if you fail to file FBARs in multiple years. Otherwise, the determination will depend on your knowledge, sophistication, and experience as an investor.
#29: What is the penalty for failing to file a Form 8938? The penalty for failing to file a Form 8938 with your tax return is an automatic $10,000.00, increased up to $60,000 if you fail to file after receiving notice from the IRS. Criminal penalties may also apply.
At the end of the day, the penalties for both the FBAR and Form 8938 are severe. It is not worth the risk of failing to file these forms, just as it is not worth the risk of failing to report your gains.
Conclusion
The taxation of bitcoins presents some complicated questions. I hope my answers have been helpful, although I expect they probably generate more questions than they answer. Such is the nature of most tax discussions, though. Please feel free to ask any other questions, I'll do my best to answer them.
I've noticed a significant amount of uncertainty around here about the taxation of bitcoins. In effort to provide some guidance , I've compiled some of the most common questions I've seen and tried to provide straight-forward, easy to understand answers. I am a tax attorney, but there is so much uncertainty surrounding bitcoins that I expect some people to disagree with one or more of my conclusions. If you have a contradictory opinion, please share it. We would all benefit from an educated discussion of this issue.
Keep in mind this post is intended for a layman audience. If you are a tax professional or want a detailed examination of this topic, you find this post lacking. Please don't nit pick this post with technicalities or narrow exceptions, I purposely excluded such nuances for the sake of readability.
I should note that this post does not address aggressive tax planning strategies. Such strategies are a lot of fun to discuss, but they do not belong in this type of post. If you are interested in such strategies, perhaps we can make a follow-up post on another day.
Legal Disclaimer
This post was created for general guidance on matters of interest only, and does not constitute legal advice. You should not act upon the information contained in this publication without obtaining specific advice from a tax professional. No representation or warranty (expressed or implied) is given as to the accuracy or completeness of the information contained in this post, and I do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this post or for any decision based on it.
CIRCULAR 230 DISCLOSURE To ensure compliance with requirements imposed by the IRS, I inform you that any U.S. federal tax advice in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
Topic 1: Realization
#1: Are gains on Bitcoins taxable?
Yes. This is one of the only unequivocal answers you'll find in this post. Under the Internal Revenue Code, all income is taxable, regardless of source or form. Bitcoins present a lot of interesting tax questions, but whether gains are taxable is not one of them.
#2: When do my gains become taxable?
Your gains are taxable in the year that they are realized. Realization occurs when you exchange bitcoins for any type of other property; such as cash, merchandise, or services. This includes everything from haircuts to yachts. Essentially, any transaction involving the exchange or sale of bitcoins is a realization event and triggers taxable gain.
Because I've seen a lot of misinformation on this point, I want to make myself perfectly clear. If you own bitcoins that have appreciated in value, you cannot use them to purchase a goods or services tax free. Such a purchase is an ascension to wealth, and is therefore taxable. This is no different than if you had sold the bitcoins for cash and used the proceeds to purchase the goods or services directly. Yet, one would be taxable while the other would not? The IRS would never tolerate such a blatant loophole, and neither would the courts. In fact, we already have a long line of IRS rulings and Supreme Court cases rejecting identical arguments made for other types of assets. The outcome for bitcoins will be the same.
Unfortunately, this has some serious implications for the future of bitcoin. I have to question the effectiveness of bitcoin as a medium of exchange when the user has to calculate his or her tax liability on every single transaction. As the saying goes, the power to tax is the power to destroy, and this is no exception.
Note: there is a code section that might provide some relief here, but only if bitcoins are categorized as a foreign currency. Under this code section, the use of bitcoin to buy goods and services would be tax free as long as the transaction was personal (i.e. not for business or investment) and did not generate more than $200 of gain.
#3: What if I sell my bitcoins but do not withdraw the proceeds from the exchange?
It doesn't matter, your gains were realized the moment you sold them. It is irrelevant whether the proceeds from the sale are kept in your bank account or your exchange account, you still have a realized gain for tax purposes.
#4: What if I exchange my bitcoins for altcoins?
This is a fair question and implicates what is known as a "like kind exchange." Like kind exchanges do not trigger realization, and therefore are tax-free. Although it's technically possible for bitcoins and altcoins to qualify for-like kind treatment, I think it's exceedingly unlikely. The regulations for like kind exchanges require the two property types to have the same rights, characteristics, and obligations. Whether altcoins and bitcoins meet this test is uncertain, but I would tend to think not. Additionally, if characterized as a foreign currency, bitcoins would be automatically barred from like-kind treatment anyways. Thus, there are two significant legal hurdles that must be overcome before bitcoin and altcoins can qualify as for like-kind status. Although nothing is for certain when it comes to bitcoins, I'm fairly confident that like-kind treatment will fail at one or both of these hurdles. Thus, I would not suggest that you try to qualify such a transaction as a like kind exchange until further guidance on this issue is given by the IRS.
#5: So how can I avoid realizing gains on my bitcoins?
The only way to avoid realization is to hold your bitcoins without selling or exchanging them. If you were hoping for a different answer, I'm sorry. Whether you decide to actually report you realized gains is of course a different matter, but as far as the law is concerned, you have realized gains upon any sale or exchange of your bitcoins.
#6: How does the IRS know about my gains?
The IRS only knows what they are told. This means that they have no knowledge of your bitcoin transactions unless someone tells them. There are four ways this can happen.
First, bitcoin exchanges or payment processors may report your transactions to the IRS by filing a form 1099. However, these businesses do not appear to be subject to the 1099 requirements (although that will probably change), and its unlikely they would voluntarily do so. So for now, this is probably won't happen. Keep in mind that the exchange or payment processor will need your social security number to file a Form 1099.
Second, your bank may file a Suspicious Activity Report ("SAR"), which could trigger an investigation for money laundering and tax evasion. Banks are required to file SARs for suspicious wire transfers that are greater than $5,000. Most banks are overly cautious and automatically treat any large international transfer as suspicious. So, if you transfer large amounts of money to/from an international exchange, its likely your bank will file a SAR. This doesn't mean that you are automatically flagged for investigation, but it puts you on the radar. The larger and/or more frequent your transfer(s), the more likely it will become a legitimate red flag that could lead to an investigation. Keep in mind that your bank is prohibited from telling you whether or not they filed a SAR against you.
Third, someone can rat you out to the IRS, which happens far more often than you might think. The simple fact is that people get jealous, and if they've heard that you've made lots of tax free money on bitcoins, they might get tempted to make sure justice is served. There's also that nice reward the IRS will pay them based on how much money the IRS ultimately recovers from you.
Fourth, you voluntarily and accurately report your gains on your tax return. That might sound ridiculous to some people given the inherent anonymity of bitcoin, but there are some very rich people in prison right now who used to think the same thing about their Swiss bank accounts. The fact is that penalties for failing to report income are significant. This includes the possibility of criminal prosecution. You can also add to this the additional penalties for failing to report foreign financial accounts (discussed below), which can be even more severe.
At the end of the day, you have a decision to make. You can comply with the law and pay taxes just like everyone else, which although annoying, is really not that big of a deal. Alternatively, you can violate the law and hope that you don't get caught. Maybe you will, maybe you won't. If you are caught, though, the amount of money you'll be forced to pay in penalties and interest will drastically exceed the amount you saved. That's not to mention the possibility of a felony criminal conviction and all the negative consequences that accompany it (including a prolonged stay at Club Fed). Personally, I have seen the havoc wreaked on people's lives by tax crimes and I would never want to be in their shoes. Neither should you.
Topic 2: Recognition
#7: How do I calculate my gain or loss?
Gain or loss is calculated first on each bitcoin transaction, then on a an aggregate basis for the year. Basically, gain or loss is computed by taking the sales price of each bitcoin and subtracting it's cost. The technical terms are amount realized and basis. Although simple in concept, determining amount realized and basis can be quite complex (see below for more information).
Your tax preparation software will automatically perform these calculations, so the actual mechanics aren't really necessary for you to understand. However, you'll have to know the basics in order to enter the correct information into the software.
#8: What is my Basis?
Generally, basis is equal to cost. So, if you purchase 1 BTC for $500, then your basis is $500. You can also add to this amount any acquisition costs like broker commissions or wire transfer fees. So, let's assume a 1% fee and a $5 wire transfer fee. This would mean your basis is $500 + $50 + $5 = $555.00. If you later sell that bitcoin for $900, your gain would be [$900] - [$555] = [$365].
#9: How do I determine my basis in each bitcoin?
If you own bitcoins that were purchased at different times and at different prices, determining basis can be quite complex. This is because bitcoins are fungible. Once a bitcoin is purchased, it becomes indistinguishable from your other bitcoins stored in the same wallet or account. In a subsequent sale or exchange, there is no way to identify the bitcoin being transferred out, and therefore you cannot accurately determine its cost or acquisition date.
Contrary to what you might have heard, you cannot just guess it's cost or arbitrarily choose the one that gives you the lowest tax liability. The IRS requires you to use a system with rules that will produce a reasonable and consistent result. As long as you use it year-to-year and the chosen method does not always give you the highest basis available, the IRS will probably respect it.
The default system (and the one generally preferred by the IRS) is to assume that your bitcoins are sold in the order they were acquired. Thus, the first bitcoin you purchase is assumed to be first bitcoin you sell. This is called the FIFO method ("First in, First Out"). There are some other methods available, such as LIFO ("Last In, First Out") and Average Cost Basis, but I would caution against using any system other than FIFO until additional guidance on this issue is provided by the IRS.
I'll note that it's theoretically possible to avoid this problem altogether if you keep each and every bitcoin purchase in separate wallets or accounts. This would allow you to trace the actual cost of each bitcoin you later sell or exchange, alleviating the need for the FIFO (or alternative) method.
Either way, determining cost will require some detailed record keeping. I will discuss record keeping in more detail below, but remember that the burden to prove basis is on you. The IRS will not give you the benefit of the doubt here. If you cannot prove the cost of each bitcoin, they will assume it was $0. Obviously you don't want that to happen, so keep good records of your bitcoin purchases.
#10: What if I mined my bitcoins, what is my basis then?
This is a very difficult question to answer with any degree of certainty. The problem is that bitcoin mining is a completely unique activity that yields an even more unique product. To reach an answer, one must resolve some difficult tax issues. Namely, what is bitcoin mining and how do we classify the bitcoins it produces?
Unfortunately, addressing these two issues would be a lengthy and detailed post in itself, so I cannot fully address them here. Suffice it to say that bitcoin miners will need a very competent tax advisor to make sure their gains are properly reported.
Not to leave you without any guidance whatsoever, the answer will most likely depend on the size and scope of your mining activity. Large scale miners should probably treat themselves as a manufacturing business, and the bitcoins they produce as inventory held for sale to customers. Such bitcoin miners would not determine their gains in the same manner as normal investors. They would compute income at the end of the year by figuring their total sales and then subtracting "cost of goods sold." The latter would take into account the cost of producing bitcoins, such as electricity. Other expenses, like depreciation on the mining rig, would presumably be deductible as an ordinary business expenses. Obviously this implicates some complex accounting rules that are far beyond this post. A tax advisor with some knowledge of these rules would be needed to accurately determine your tax liability.
Smaller mining operations can probably get away with treating their mining as an "activity for the production of income," as opposed to a manufacturing business. In such a case, they would follow the same rules for determining gain or loss as normal rules investors. I suspect their basis in this case would be determined by allocating their mining costs on a pro rata basis, assuming they can reasonably track and allocate such expenses (such as electricity). The safest and most conservative approach, on the other hand, would be to use a basis of zero. Depreciation and other indirect expenses would likely be deductible as an itemized expense, similar to a general investor (see below).
I must emphasize that neither of these treatments is a perfect fit. I expect different tax advisors to reach different conclusions on the correct treatment. The goal in any case is to use the best method of matching income to expenses, whatever that is. Presumably the IRS will respect your chosen method as long as you can convincingly argue that it is the best at accomplishing this goal.
#11: What if I received my bitcoins as payment, what is my basis then?
If you sell goods or services and accept bitcoin as payment, your basis in those bitcoins is equal their fair market value at the time they were received. Generally, this is determined by reference to the average market price on that day. Thus, if you wrote a software program for someone and received 1 BTC as payment on November 1st, your basis in those bitcoins is equal to the average price of 1 BTC on that day.
The choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
#12: How do I determine Amount Realized (i.e. Sales Price)?
This depends on the transaction and if you sold bitcoins for cash or exchanged them for goods/services.
In the case of a sale, amount realized is equal to sales price, less any selling costs you incur in the transaction (like commissions or wire transfer fees). So, if you sell a bitcoin for $900 and incur a 1% transaction fee, your amount realized is $900 - $9 = $891.00.
If you exchanged bitcoins for goods or services (instead of selling them), then amount realized is more complicated. This is essentially a barter transaction, where the default rule is to use the fair market value of the goods or services received in the exchange. For example, if you purchased a laptop on November 29th with bitcoins, your amount realized would be equal to the Fair Market Value of the laptop on that date. The easiest way to determine Fair Market Value is by reference to the sales price, although an alternative method can be used if yields a more accurate value.
Presumably, the sales price of most goods or services will be denominated in dollars (even though payment is made in bitcoin). Thus, if the laptop's price was $1,500, you can safely assume that it's FMV was also $1,500. If the sales price is denominated in bitcoin (instead of dollars), you'll have to convert it into dollars using the average exchange price on that day. As mentioned above, the choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. The most conservative option would be to use the price from the exchange that you purchased the bitcoin in the first place. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
Topic 3 Character
#13: Are my gains "capital gains?" Probably. The first hurdle to clear is the classification of bitcoins as a capital asset, because capital gains treatment applies only to capital assets. This is actually a pretty easy hurdle to clear because the definition of a capital asset includes all forms of property by default, unless specifically excluded. So, if you look at the list of excluded property under § 1221(a) of the code, you'll see that bitcoins are not excluded by name, nor would they fall within any of the excluded categories. (keep in mind that this is not true if bitcoins are held as inventory in a trade or business, which might be the case if you mine bitcoins, nor is it true if bitcoins are classified as a self-created intangible asset like a copyright or artistic composition, which is unlikely but possible).
Thus, bitcoins are a capital asset in the hands of most taxpayers and qualify for capital gains treatment. If you were lucky enough to buy your bitcoins more than a year ago, then your gains would qualify for the lower preferential tax rate given to long term capital gains (probably 15%, but it depends on your income level).
If you held you bitcoins for one year or less, then the gains are characterized as short term capital gains, which are taxed at ordinary income tax rates (i.e. the same rate as your paycheck).
Note that a different characterization would apply if bitcoins are treated as a foreign currency. Whether bitcoins will be so treated is uncertain, but if you're curious, read the answer below.
#14: What if I mined my bitcoins?
As mentioned above, the tax treatment of bitcoin miners is very uncertain. The primary question here is whether you are engaged in a trade or business, and if so, if your bitcoins should be classified as "inventory." If the answer to both of these questions is "yes," then your bitcoins are not capital assets and your gains are taxable as ordinary income. If the answer to either of these questions is "no," then your gains are taxable just like a normal investor (i.e. as capital gains).
Unfortunately, there is no clear answer to these questions. For some bitcoin miners the answer will be yes, for others it might be no. The tax treatment will depend on the specific facts and circumstances of your case, although the bigger your mining operation, the more likely it should be treated as a trade or business (and therefore taxed at ordinary rates). I suggest consulting with a competent tax advisor to determine whether your mining activities rise to that level.
#15: What if I'm a "day trader?"
Generally, the tax treatment for day traders is the same as a regular investor. Of course there are exceptions to this rule, such as the mark-to-market regime, but they would not apply to bitcoins without some affirmative directive by the IRS.
There is also the possibility of your day-trading activities rising to the level of an actual business (which would make your gains and losses "ordinary.") The IRS is extremely stingy when it comes to classifying day-traders in this manner, though, so it's unlikely you have anything to worry about here. However, you should consult with a tax advisor to be sure about your status.
#16: What if Bitcoins are classified as a collectible?
As a collectible, the gains would still be "capital gains," but the lower tax rate given to long term capital gains would be fixed at 28% (instead of the 15% most taxpayers would use). However, it's pretty unlikely at this point that bitcoins would be classified as a collectible. First, bitcoins are not specifically named in the code section that defines "collectibles." Second, collectibles are traditionally limited to tangible assets, whereas bitcoins are intangible assets. (Note: there might be an argument that physical bitcoins, such as those made by Casacius, are "collectibles." However, that would still require some declaration by the IRS or Congres to make certain). Thus, for now, it's safe to conclude that bitcoins are not a collectible and regular long-term capital gains treatment applies.
#17: What if bitcoins are treated as a foreign currency?
As a foreign currency, bitcoins would be disqualified from capital gains treatment (even though still technically a capital asset). In other words, all bitcoin gains would be taxable at ordinary income tax rates regardless of holding period. Although this sounds like bad news for bitcoin investors, there are some caveats that arguably outweigh the negatives of this outcome .
The biggest is the exception under the foreign currency rules for "personal transactions." Under this exception, gains of less than $200 are tax free as long as the transaction is not for investment or business purposes. Remember that without this exception, every exchange of bitcoins for goods or services would trigger taxable gain, which creates a significant burden on the use of bitcoin for day-to-day transactions. Thus, this exception is a potential game changer for the future of bitcoin. Assuming that most consumer transactions would generate less than $200 of gain, there would be no tax consequences to the use of bitcoin for personal spending. The implications of this outcome cannot be overstated.
If the gains are greater than $200 (on personal transactions), they are no longer tax free. However, instead of being taxed as ordinary income, the code allows them to be treated as capital gains instead. Thus, the gains would be eligible for the lower tax rate given to long-term capital gains . Although not as significant as the $200 exemption mentioned above, this still offers a benefit to consumers who use bitcoin for day-to-day personal transactions.
Just to be clear, any gains on non-personal transactions would be ordinary income. So, investors would lose the lower tax rate given to long-term capital gains. However, this isn't as bad as it sounds. First, many investors - particularly day traders - do not hold bitcoin for longer than one-year anyways, so their tax rate is effectively unchanged. Second, because they are no longer "capital," bitcoin losses would be fully deductible (i.e. not subject to the $3,000 limitation discussed below). Finally, investors stand to benefit indirectly from the $200 exemption mentioned above. That is because this exemption should help propel the wide spread use of bitcoin, is likely to be the greatest catalyst for future market appreciation.
#18: So, are bitcoins foreign currency?
It is impossible to say at this point whether bitcoins are a foreign currency for purposes of income taxation. No US court has directly addressed this issue, nor has the IRS published any guidance . The closest we've come is an obscure federal court decision written by a Magistrate judge involving bank fraud chargers (which has nothing to do with taxation) and a ruling by FinCen that bitcoin is not a currency. However, the FinCen ruling uses an extremely narrow definition of currency that has no application whatsoever to the issue of taxation.
Thus, bitcoin users and tax professionals are left to guess as to it's proper classification. The conservative approach is to treat bitcoin as a normal capital asset until some further guidance is issued by the IRS. This is consistent with the general attitude towards bitcoin expressed by the IRS, as well as some notable legal scholarship on the issue. When dealing with uncertainties such as this, it is generally advisable to proceed with the most cautious option available, which would be treating bitcoin as a capital asset (not a foreign currency).
This is not to say that you would be without a basis for treating bitcoin as a foreign currency. Indeed, bitcoins are intended to serve as a medium exchange and lack any other functional purpose. Unlike gold, silver or other commodities that have served as currency in the past, bitcoins do not have any industrial or commercial usefulness aside from exchange. This arguably makes them much more similar to a currency than a commodity or other capital asset.
Of course, the fact that bitcoins are not minted by any foreign government or bank casts some doubt as to whether they are truly foreign. However, the internal revenue code does not employ the term foreign currency. It distinguishes currency as being functional or nonfunctional. Further, it declares that only the US dollar can be a functional currency. Thus, the fact that bitcoin is not produced by a foreign government is not actually relevant, because any currency that is not the US dollar is automatically a non-functional currency and therefore subject to the foreign currency rules.
In the end, the decision of whether to treat bitcoins as a foreign currency is up to you (and your tax advisor). The trouble is that the IRS could subsequently try to undo your elected treatment and assess the additional tax that would result. Of course, it's possible that the IRS will ultimately agree with your treatment of bitcoin as a foreign currency, in which case you would not be at any risk by adopting the treatment early. I wish I could provide a more concrete recommendation here, but at this point it's just too uncertain.
Topic 4: Deductions
#19: What kind of expenses can I deduct as an investor?
You are permitted to deduct expenses for the production of income on your tax return as an "itemized deduction." However, this deduction is fairly meaningless for most investors. This is because you must actually itemize your deductions instead of taking the standard deduction, which many taxpayers do not. Additionally, such expenses fall within the category of "miscellaneous itemized deduction," which are only deductible to the extent they exceed 2% of your Adjusted Gross Income. The 2% floor is particularly troublesome because most investment expenses are pretty insignificant. Recall that you've already accounted for commissions and wire transfer fees in determining "amount realized" and "basis." Your remaining expenses might include:
• Investment interest (limited to the amount of your net gains), • Rent expense for a safety deposit box (this could arguably be extended to include the cost USB drives for cold storage), • Consulting fees for the tax treatment of bitcoin, • Depreciation on equipment used in the production of income, such as your computer (however, you'll have to allocate the cost of the equipment between personal use and investment use, which is likely to reduce this deduction substantially in most cases).
In most cases, these deductions will be quite small. Other expenses may or may not be available to you, depending on your specific situation, though. You should consult with your tax advisor to be certain of your deductible expenses.
#20: What kind of expenses can I deduct as a miner?
If your mining operation is substantial and continuous enough to be considered an actual business, then you can deduct all of your ordinary and necessary expenses. This would include the cost of electricity and depreciation on your mining rig, among others. If your mining operation is not substantial or continuous, you would deduct expenses like an ordinary investor.
As mentioned above, the tax treatment of bitcoin miners is exceptionally uncertain. So, its important that you obtain the advice of a tax professional with regards to whether or not your activity rises to the level of a trade or business.
Topic 5: Record Keeping
#21: What kinds of records should I keep? You are required to maintain records sufficient for determining the amount of your gain or loss, as well as the holding period of your bitcoins. This is a flexible standard and depends on the circumstances. Ideally, you should maintain a log of all your bitcoin acquisitions and dispositions, including the price, date, and related address of each transaction. Many exchanges make this information available to you in the form of a downloadable spreadsheet.
#22: How long should I keep my records?
The IRS can generally go back and audit your tax returns for a period of 3 years. However, they can go back 6 years in some cases. Thus, the safest answer is to save records for 6 years (determined from the date you filed you tax return).
#23: What if I don't maintain records?
You are required by law to maintain records, so failing to do so will result in the assessment of civil penalties against you in a subsequent audit. Penalties aside, it is in your best interest to maintain records because the burden is on you to prove your basis. Thus, if you cannot reasonably establish your purchase price, the IRS will assume it is zero. The same goes for holding period (which would cause you to lose the benefit of the lower long term capital gains rate).
This assumption can be disastrous if you engage in a lot of bitcoin transactions. For example, imagine a day trader who buys $2,000 worth of bitcoins after seeing a specific market signal, which he then sells shortly after for a small profit of $100. He does this only once per day. If he is subsequently audited and lacks the necessary documentation to prove his basis, the IRS will assume it was zero. Thus, he would be taxable on $2,100 of gain every day, instead of just $100. That is a total taxable gain of $766,500 for the year, compared to $36,500if he had kept adequate records.
Topic 4: Foreign account reporting
The requirements to report foreign accounts are complex and convoluted, such that many taxpayers and tax preparers overlook them entirely. However, the penalties for doing so are severe - even criminal in some cases. Therefore, I feel compelled to address the reporting requirements for foreign accounts even though I rarely see any questions on this issue.
#24: What are the foreign account reporting requirements?
There are two separate reporting requirements under federal law, each created by a different statute (The Bank Secrecy Act and the Foreign Account Tax Compliance Act). Although the exact wording is different between the two statutes, they generally require reporting of financial accounts held at foreign financial institutions. Whether bitcoin wallets and exchange accounts fall meet the definitions for these terms is debatable.
#25: Are paper wallets subject to the foreign account reporting requirements?
Probably not. The reporting requirements generally apply to financial accounts held at foreign financial institutions. It's pretty difficult to imagine that a paper wallet containing your bitcoins would satisfy this test. However, it's believable that the IRS will seek a change to this rule sometime in the future. For now, though, it's safe to assume that paper wallets are not subject to the reporting requirements.
#26: Are electronic wallets and accounts at a foreign bitcoin exchange (such as Mt. Gox or BTC-e) subject to the requirements?
Yes, although there's room for disagreement here. The answer depends on whether electronic wallet providers and bitcoin exchanges are "foreign financial institutions," and whether an account with one of these exchange is indeed a "financial account."
Unfortunately, an analysis of these definitions and the myriad of exceptions that apply is too large of a task for this post. However, because foreign exchange accounts accept deposits of fiat and provide brokerage services, it's hard to argue that they are not subject to one or both of the foreign financial reporting requirements. The case against reporting electronic wallets is slightly stronger, but is still quite weak in my opinion. I would recommend that bitcoin holders err on the side of caution and report such accounts (subject to the minimum balance requirements discussed below) until further guidance is provided by the IRS. As you'll see below, the penalties for failure to file are tremendous and not worth the risk.
#27: What is the minimum account balance for reporting the reporting requirements?
The first threshold is provided by the Bank Secrecy Act and is $10,000.00. The test if whether the total aggregate value of your foreign accounts exceeds $10,000.00 at any point during the year. If so, you must report the highest balance for each account during the year by filing an FBAR with the IRS. This form is filed separate from your income tax return and must be received by June 30th of each year.
The second threshold is provided by the Foreign Account Tax Compliance Act (FACTA). The test is whether the aggregate value of your accounts exceeds $50,000.00 on the last day of the year, or exceeds $75,000 at any point during the year (for unmarried filers). If so, then you must report the highest balance of each account during the year by filing Form 8938 with your income tax return. Note: this is in addition to the FBAR filing.
#28: What is the penalty for failing to file an FBAR? The penalty for failure to file an FBAR under the BSA varies depending on "willfulness." If your failure to file was not willful, the penalty is capped $10,000. If your failure was willful, the penalty is the greater of $100,000 or 50% of the highest account balance for each account. Criminal penalties can also apply.
Willfulness is defined generally as the intentional disregard of a known legal duty. The IRS will typically asserts willfulness if you fail to file FBARs in multiple years. Otherwise, the determination will depend on your knowledge, sophistication, and experience as an investor.
#29: What is the penalty for failing to file a Form 8938? The penalty for failing to file a Form 8938 with your tax return is an automatic $10,000.00, increased up to $60,000 if you fail to file after receiving notice from the IRS. Criminal penalties may also apply.
At the end of the day, the penalties for both the FBAR and Form 8938 are severe. It is not worth the risk of failing to file these forms, just as it is not worth the risk of failing to report your gains.
Conclusion
The taxation of bitcoins presents some complicated questions. I hope my answers have been helpful, although I expect they probably generate more questions than they answer. Such is the nature of most tax discussions, though. Please feel free to ask any other questions, I'll do my best to answer them.