This financial year is the first in which many bitcoin users will consider putting their cryptocurrency gains on their tax returns.
When a bitcoin was worth $5 or less, most people didn’t make enough money on them to worry about taxes. But 2013’s price run-up pushed plenty of bitcoiners into a category where unreported gains could attract attention – and possible sanctions – from the US Internal Revenue Service and other tax authorities.
Some will quietly pocket those earnings, tax free, hoping that bitcoin’s anonymity will keep the government bean counters from their doorstep. But others are grappling with how to report their gains to tax authorities who, in the United States and most countries, have provided little to no guidance on how to do that.
One Washington State programmer walked into his local H&R Block for help reporting $77,000 in gains from mining and trading in bitcoins and litecoins. The accountant there turned him away.
“Midway through explaining how mining is really part of the issuance of the currency, he sort of just glossed over,” the programmer posted on reddit.
The main questions plaguing would-be cryptocurrency taxpayers are how to categorize bitcoin gains or losses, and what events are taxable.
Currency, asset or investment?
Most experts expect that the IRS will treat bitcoins as either a foreign currency, or, more likely, a capital asset or investment. Some events are clearly taxable, like selling bitcoins for US dollars, whereas others might be taxable depending on one’s interpretation of existing regulations that were not written with cryptocurrency in mind.
Even tax professionals who want to report their own bitcoin gains are struggling to figure out how to do it properly. Cryptocurrency miners, who invest in high-end computers to process transactions on the block chain and are rewarded with newly minted bitcoins, face some of the most difficult questions.
“It’s not that easy to understand,” said Yana Kesler, a certified public accountant from Philadelphia, who bought a $7,200 mining rig with her husband last year, spent $2,200 for hosting services and generated about 50 bitcoins. She then needed to decide how to report the income and how to deduct the expenses. Was this activity a business? An investment? A hobby?
“Usually a business is something you participate in,” Kesler reasoned, while mining seems more like a “passive investment”.
Tyson Cross is a San Diego tax attorney who plans to help a handful of clients file tax returns involving bitcoins this year. Cross addresses how to report mining income and other bitcoin tax questions on his website, Bitcoin Tax Solutions. He said:
“Nothing’s ever existed like bitcoin mining. It’s a completely unique activity. You can try your best to fit it into existing laws, but anyone’s guess is as good as someone else’s.”
Like all the quotes from tax experts in this story, Cross’s statements should not be considered tax advice, which is best sought directly from a qualified professional.
Other tough questions include how to figure out the basis, or original cost, of bitcoins that were purchased and later sold at a higher price. Users may not have kept records, especially if they bought their bitcoins early, and didn't expected them to amount to much.
Calculating tax owed
One particularly vexing possibility is that bitcoin users might need to calculate tax owed every time they purchase something with bitcoins. The reason? If you're shopping with bitcoins that are worth more than they were when you got them, spending those bitcoins could be a taxable event.
For instance, if you bought 1 BTC for $100 earlier this year, then used it to buy a computer when the bitcoin price hit $1,000, you could owe tax on the $900 appreciation.
“That can come as a surprise to a typical consumer, who may not be accustomed to tracking his basis in currency, or computing gain, or loss in connection with a personal transaction,” wrote Mindi Lowy and Miriam Abraham of PricewaterhouseCoopers in a November report for the publication Tax Notes.
Calculating income tax every time you spend bitcoins might not sound like a big deal if you only spend them occasionally. But with more than 1,000 merchants now accepting bitcoins, some people will be making more and more small transactions over the course of a year, presenting an accounting nightmare when tax time comes.
When Cross posted an overview of bitcoin tax issues on reddit, this potential problem created a stir. “Some people were alarmed by that. […] It’s a serious problem for the future of bitcoin,” Cross said.
As if that were not complicated enough, the Washington State programmer who sought tax advice from H&R Block had another quandary when figuring out taxes due on bitcoin purchases. He ordered some merchandise and paid with 2.6 BTC – worth about $2,500 at the time. He was planning to report the difference between the bitcoins’ value when he acquired them and their higher value when he spent them. But he hit a snag. The programmer told CoinDesk:
“I actually have not had the seller for all of the merchandise deliver – and subsequently [they ignored] my attempts at contact – so I'm not sure if I should deduct that fraud from my gains or just leave it all in to be safe.”
Another worry is whether Americans holding bitcoins in foreign-based exchanges might be subject to a law that requires the reporting of foreign bank accounts containing more than $10,000. “I'd be shocked if many people realize that their foreign bitcoin accounts are arguably subject to the reporting requirements,” Cross said.
Some reddit members responded to Cross’s post by saying they wouldn’t bother reporting bitcoin gains to the IRS. “After reading all this, all I got was ‘paying taxes on bitcoins is too hard so just don't worry about it’,” one person wrote.
The US Taxpayer Advocate Service (TAS), in a recent entreaty to the IRS to issue guidance on bitcoin taxes, had predicted this attitude: “The lack of clear answers to basic questions such as when and how taxpayers should report gains and losses on digital currency transactions probably encourages tax avoidance,” says the TAS 2013 Annual Report to Congress.
Since bitcoin wallets have no names attached and bitcoin exchanges do not appear to be reporting transactions to the IRS at this point, non-reporters may just get away with it. Then again, they might not, Cross warned – there are multiple ways in which the government could find out about taxable bitcoin transactions.
If a customer transfers a large amount of money from an international bitcoin exchange to a regular bank, for instance, the bank may file a Suspicious Activity Report, which could trigger a government investigation looking for money laundering or other illegal activity.
Or someone might “rat you out to the IRS”, Cross warned.
“[P]eople 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,” he said.
The TAS report stated that “many law-abiding taxpayers want to comply and to distinguish themselves from tax evaders”. Conversations with potential clients led Cross and another tax expert, Carl M Force, to believe that there are plenty other law-abiding bitcoin users out there who want to do the right thing.
But not everyone.
“Your crooks and drug dealers are not going to comply at all,” said Force, who aside from being a certified public accountant is a special agent with the Drug Enforcement Administration. “If you’re going to go on Tor, the dark Internet, the people on there are not going to be asking advice on how to file their taxes,” he said.
Other bitcoin users may resist reporting their bitcoin gains for more philosophical reasons. One San Francisco entrepreneur told CoinDesk:
“I don't know whether I plan to report them or not. The laws around taxes of bitcoin appears to be unfair and unjust. It's all complex and seems unnecessary to me.”
On the other hand, some bitcoin enthusiasts want to include bitcoins on their tax returns in order to raise the profile of the growing bitcoin economy with the authorities, and to establish that bitcoin is used by law-abiding citizens – not just drug dealers.
“I hope people do report this year. It will show to the government that there is more activity, and maybe they will give better guidance,” said Kesler, who decided to categorize her household’s mining earnings as investment income.
A more powerful incentive is fear. People who have realized millions of dollars in unreported gains, or who are prosecuted for holding large amounts of money in unreported overseas accounts, could face stiff penalties or even criminal prosecution.
“You’re potentially looking at some serious consequences,” Cross said. “The IRS would love to make a case out of somebody out there and send a message that bitcoin income is taxable.”
Whether Americans owe tax on bitcoin gains is not controversial among experts – all agree that bitcoin income is taxable at some point. But there are many ways to approach how to calculate and report those taxes. Cross said:
“We don’t have any guidance from the IRS, so every position you take is a gamble. If you’re risk averse, take the most conservative approach, pay more taxes than you possibly should just so you’re safe, and know you can get a refund in the future.”
For those struggling with calculating cost basis and other bitcoin tax mathematics, websites have sprung up to help, such as BitcoinTaxes. Seattle software developer Colin Mackie created the tools on the site to streamline his own tax preparation when he realized that figuring out what he owed on just under $100,000 worth of bitcoin gains was going to be tricky.
“Last year, it probably wouldn’t have mattered. This year, there’s enough people noticing,” Mackie said. At that point, he knew he would have to report his bitcoin gains.
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