Bitcoin Tax Treatment for US Citizens Part 1 of 7 Realization of Bitcoin Gains

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This is Part One in a Seven Part Series Covering Taxation of Bitcoin for US Citizens

Written by Tyson Cross a Tax Attorney based in San Diego

Part One – Tax Realization of Bitcoin Gains  You are Here
Part Two – Tax Recognition of Bitcoin Gains
Part Three-  Tax Character of Bitcoin Gains
Part Four – Tax Losses and Bitcoin
Part Five- Tax Deductions Related to Bitcoin
Part Six-  Tax Record Keeping related to Bitcoin
Part Seven- Bitcoin Foreign Account Reporting Requirements

Legal Disclaimer

This publication was written 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 publication, 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 publication 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.

 

 

Introduction

The proper treatment of bitcoin for federal income tax purposes is a confounding subject.  This article will try to provide some guidance by answering common questions on the topic of bitcoin taxation in language that is straightforward and easy to understand.  The goal is to help educate non-tax professionals on the general tax rules that apply to bitcoin investments and usage.   As such, this article purposefully omits narrow exceptions and nuances for the sake of readability.  It also does not discuss aggressive tax planning strategies.  Tax professionals and those desiring a technical discussion of bitcoin taxation might find this article lacking, but it should be helpful for those trying to understand the tax treatment of bitcoins and other cryptocurrencies.  More information on these topics may be found at www.BitcoinTaxSolutions.com.

 

Topic 1: Realization

 

#1: Are gains on Bitcoins taxable? 

Yes.   This is one of the only unequivocal answers you’ll find in this article.   All income is taxable, regardless of source or form, unless the Internal Revenue Code specifically states otherwise.  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?

Gains are taxable in the year 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 Bitcoin 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 goods or services without realizing gain.   Such a purchase is an accession to wealth.  It puts you in the same position as if you had first sold the bitcoins for cash and then used the proceeds to purchase the goods or services directly.  Yet, one would be a taxable transaction while the other would not?  The IRS would never tolerate such a blatant loophole, and neither would the courts.   In fact, this exact argument has already been rejected 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?

Your gains were realized the moment you sold the bitcoins.  It is irrelevant whether the proceeds from the sale are kept in your bank account or your exchange account, you have still realized a gain for tax purposes.

 

#4:  What if I exchange my bitcoins for altcoins?

The answer to this question implicates what is known as a “like kind exchange.”  Like kind exchanges do not trigger realization, and are therefore tax-free.  Although it’s technically possible for Bitcoin and altcoins to qualify for-like kind treatment, 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 Bitcoin meet this test is uncertain, but I would tend to think not.  Additionally, Bitcoin would be automatically barred from like-kind treatment anyways if it is characterized as a foreign currency.  Thus, there are two significant legal hurdles that Bitcoin must be overcome before qualifying for like-kind status with another altcoin.  Although nothing is for certain when it comes to bitcoins, I’m fairly confident they 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 unless further guidance on this issue is given by the IRS.

 

#5: So what can I do to 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 it is told.  This means that it has no knowledge of your bitcoin transactions unless someone tells them.  Here are four way that can happen (others may exist).

 

First, your bitcoin exchange or payment processor may report your transactions to the IRS.  This would be done with a Form 1099, which you’ve probably encountered at one time or another in a different context.   However, it does not appear that bitcoin transactions are currently subject to the 1099 reporting requirements (although that will probably change).   Thus, unless they voluntarily file a 1099 against you, it is unlikely that the IRS will receive a report of your bitcoin transactions.  Note that they would need your social security number to file a 1099 in your name.

 

Second, your bank or bitcoin exchange might file a Suspicious Activity Report (“SAR”).   US banks and bitcoin exchanges are required to file SARs for wire transfers that are “suspicious” and larger than $5,000 ($2,000 in the case of bitcoin exchanges).   The meaning of “suspicious” is very vague and highly discretionary.  Out of an abundance of caution, many banks automatically treat all international transfer as “suspicious.”  So, if you’ve sent or received a wire transfer of more than $5,000 to/from an international bitcoin exchange like Mt. Gox or BTC-e, you can be pretty sure that your bank has already filed a SAR against you (although they are prohibited from telling you if they did, so you’ll never know for sure).   The larger and/or more frequent you SAR filings, the more likely they will become a legitimate red flag and trigger an investigation.  Although FinCEN is generally concerned with money laundering activities, the IRS does have access to FinCEN filings and it is common for IRS special agents to participate in FinCEN investigations.

 

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 with bitcoin, they might get tempted to make sure justice is served.  There’s also that nice reward the IRS will pay them for snitching.

 

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 is admittedly unpleasant.  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 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.

 

Conclusion

Gains on bitcoins are taxable income. They become taxable when you sell bitcoins for cash or exchange them for goods or services. The IRS does not receive any direct information regarding your bitcoin transactions, but it has other ways of finding out. The monetary and criminal penalties for failing to report gains are not worth the taxes you’d save.

Continue to Part 2 – Tax Treatment for Bitcoin and Recognition of Gains

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