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.
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. 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?
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 accession 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 or bitcoin exchange may file a Suspicious Activity Report ("SAR"), which could trigger an investigation for money laundering and tax evasion. US banks and Money Service Businesses (MSBs) (which includes US bitcoin exchanges) are required to file SARs for suspicious wire transfers that are greater than $5,000 ($2,000 in the case of MSBs like coinbase.com). Most banks are overly cautious and automatically treat any international transfer over $5,000 as suspicious. So, if you transfer large amounts of money to/from an international exchange using your bank account, 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/exchange is prohibited from telling you whether or not they filed a SAR against you. (EDIT: I edited this paragraph to clarify that MSBs include bitcoin exchanges under a recent FinCEN ruling. Thus, bitcoin exchanges like coinbase.com are therefore subject to the same reporting requirements under FinCEN as your bank.)
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.
TL; DR: 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.