Bitcoin: How are the Transactions Taxable?

The Bitcoin has grown in popularity and value since its introduction in 2009. Investors, merchants and consumers have shown an interest in the Bitcoin, but face a great deal of uncertainty while the IRS tries to figure out how it will tax virtual currency. In the National Taxpayer Advocate’s 2013 Annual Report to Congress, Nina Olson, the taxpayer’s voice at the IRS, addressed the Bitcoin and acknowledged the lack of guidance from the IRS concerning the tax treatment and reporting requirements associated with virtual currencies. “A virtual currency is a digital unit of exchange that is not backed by a government-issued legal tender. Virtual currencies can be used entirely within a virtual economy, or in lieu of a government-issued currency to purchase goods and services in the real economy”.

The IRS and tax experts have identified various tax compliance risks associated with virtual economies and currencies, including underreporting, mischaracterization, and evasion.

The Government Accounting Office, or GAO, addressed the risk taxpayers face due to uncertainty surrounding:

1. whether income from virtual currencies is taxable
2. how to keep adequate records of virtual transactions
3. how to calculate basis for gains

The GAO points out in the report the difficulty for individuals receiving income from virtual economies to determine basis for calculating gains and the reporting of gains as taxable income. Virtual currency transactions may be subject to third-party information reporting when the transactions involve the use of a third-party payment network.(Third-party exchanges allow Bitcoin users to exchange their Bitcoins back to government-issued currencies, such as U.S. dollars, euro, or yen.)

Although taxpayers are responsible for recording Bitcoin transactions, all that is needed to complete a transaction is a Bitcoin address, which does not contain any personal information. Some taxpayers may try to use virtual currencies as a way to evade taxes. Bitcoin transactions can be difficult to trace due to their level of anonymity, and taxpayers may use them to hide taxable income.

Due to competing priorities and resource constraints, the IRS has not issued guidance specific to virtual currencies used outside of virtual economies. Given the relatively recent development of virtual currencies, the IRS will require much more extensive consideration before it can reasonably be prepared to do so. For more information on these evolving issues, please refer to the full report on Virtual Economies and Currencies by the GAO: http://www.gao.gov/assets/660/654620.pdf