The increasing acceptance and utilization of Bitcoin, Ethereum (Ether), and other cryptocurrencies/virtual currencies to conduct business transactions has made it imperative to be aware of the tax ramifications the accompany their usage. Although the IRS was initially silent on the tax treatment of Bitcoin, it eventually issued a notice of guidance in 2014 (Notice 2014-21) that clarified how it would treat virtual currencies. The most important takeaway from the notice was that virtual currencies should be treated as property for tax purposes (like gold or diamonds) and not as currency. Consequently, virtual currency used to buy or sell goods and services (or for investment purposes) must be valued according to the fair market value of the virtual currency at the time of each transaction and changes in value would result in a capital gain or loss. For example:
- If you received one Bitcoin (BTC) on October 12, 2017 (when it was briefly valued at $5,000) as payment for contract work, the taxable income reportable to the IRS would be $5,000.
- If you were to keep the BTC for two months (in which time Bitcoin increase in value to $7,000) and then use it to pay for business-related marketing services, you would record a business expense of $7,000 along with a short-term capital gain of $2,000.
- To add to the complexity, let’s assume you were to receive one BTC monthly (i.e. January 1st, February 1st, and March 1st) as payment for contract work and the value of each BTC was $7,000, $8,000, and $9,000 respectively. If you later used one BTC (when its value was $8,000) to purchase SEO services, you would need to report a capital gain of $1,000 due to the fact that the IRS requires taxpayers to use the FIFO (“first in, first out) method of accounting in which the BTC that was transferred is assumed to have been the earliest one you acquired (thus, a $7,000 BTC was transferred to acquired $8,000 of SEO services and a $1,000 capital gain was realized). Notably, you might be able to use “specific identification” to determine the potential capital gain or loss if you could should that the BTC being used came from a particular transaction. For example, if you had received each BTC in a separate wallet, you could purposely use the BTC received on March 1st (when the value was $9,000), and use it to pay for the $8,000 of SEO services- and thereby realize a reportable capital loss of $1,000.