IRS Notice 2014-21
The IRS has finally broken its silence regarding the taxation of bitcoins and other digital currencies. Unfortunately, not must changes by the issuance of Notice 2014-21, other than we can stop speculating about possible tax treatments in the event bitcoin is treated as a foreign currency. I’ve updated the posts on this site to reflect this change.
Here’s a quick rundown of the how the Notice affects bitcoin investors and users. Just keep in mind that these topics are covered in more detail in other posts on this site in case you want more information.
#1 Bitcoins are property, not foreign currency.
This means that capital gains treatment will apply to most people. This really isn’t a surprise and basically everyone expected this result (although some hoped for the longshot possibility of foreign currency treatment). The biggest exception is if you are engaged in a trade or business and hold bitcoin as inventory for sale to customers. This is probably a pretty small group of people, though.
#2 Every bitcoin transaction is taxable.
As I said in my first post, Bitcoin users will have to calculate their gain or loss every time they purchase goods or services with bitcoin. Yes, this is a very onerous burden and creates a significant threat to the widespread adoption of bitcoin. However, this outcome is not very surprising and is consistent with US tax laws. Hopefully the Treasury Department or Congress can be convinced to apply a “personal transaction” exception similar to the one that exists for foreign currency. But for now, this is how it will have to work.
When calculating your gain or loss, you must determine “amount realized” and “basis.” When buying goods or services with bitcoin, the amount realized is equal to the fair market value of whatever you received. When selling bitcoin, the amount realized is the sales price less any transaction fees.
The biggest issue for most bitcoin users is determining their basis. Because bitcoins are fungible, you run into the problem of tracing the cost of each bitcoin you hold. You cannot just arbitrarily choose your basis. The IRS will permit you to use the FIFO method (First in, First out). Any other method such as LIFO or Average Cost Basis is not advisable, particularly now that we know foreign currency rules do not apply.
#3 Miners recognize income in the year the bitcoin is mined.
This was a big unresolved question prior to the Notice. The amount of income is equal to the market value of bitcoin on the day it was mined. You can use any exchange price as long as its reasonable and you use it consistently going forward. The market price also becomes your basis in that bitcoin going forward. Therefore, when you sell it sometime in the future, you will subtract this amount from the sales price in order to determine your taxable gain.
Note that you can deduct your mining expenses in the same year, such as electricity and depreciation (subject to loss limitations).
#4 Miners are subject to self-employment tax if their activity rises to the level of a trade or business.
The IRS notice did not provide any guidance on when a mining activity constitutes a trade or business. A “trade or business” is generally defined as an activity engaged in on a substantial and continuing basis for the purpose of generating a profit. This does not have to a full-time activity, just one that you regularly pursue with a profit motive. Obviously, whether or not your specific activity is a “trade or business” depends on your particular situation. The more substantial and continuous your activity, the more likely it is that you’re a trade or business. You can read a little bit more about the test here . If your mining activity consists of more than just an old GPU card (or two), I suggest you consult with a tax professional to determine if you’re a trade or business. You’ll also need to get guidance on making estimated Self Employment tax payments (which is done in quarterly deposits with the IRS).
#5 The IRS Notice is retroactive.
Okay, “retroactive” is not technically the right term. The law has not changed, the IRS is just informing everybody of how they interpret it. But, they will apply these interpretations to past tax years as well as the current one. So, if you already filed 2013 taxes (or earlier years) in a manner not consistent with the Notice, you should consider amending your return because the IRS will apply the rules in the Notice to your situation.
You can find the entire IRS Notice 2014-21 here.