For a multitude of reasons, Bitcoin and similar digital cryptocurrencies have captured the attention of both technology evangelists and financial traders. To start, Bitcoin represents the first foray into currencies of this type where no governmental or single body has control of the currency and its supply. Therefore, Bitcoin is significant from a purely technical – in both a computing and monetary sense — point of view. However, Bitcoin and its successors are also interesting in the fact that there is still significant volatility in the markets. This presents the opportunity for savvy traders to take short- and long-term positions.
However, due to the nature of Bitcoin and decisions made by the IRS and U.S. Treasury mining, holding, and trading Bitcoins can subject an individual to capital gains taxes. All individuals who hold or have held Bitcoin and similar cryptocurrencies will be or are subject to capital gains tax and other informational reporting requirements.
The reason why Bitcoin miners and traders need to be cognizant of capital gains taxes and related record-keeping and reporting requirements can be traced back to a 2014 IRS Notice. In IRS Notice 2014-21, the basic tenets of Bitcoin taxation are set forth. Essentially, the notices states that while the IRS recognizes that Bitcoin is utilized as a digital currency, for tax purposes it will not be treated as a currency. Rather, Bitcoin and similar cryptocurrencies will instead need to be treated as property for tax purposes.
Since Bitcoin and similar currencies are treated as property, capital gains taxes apply when gain is realized. Thus, when a person mines a Bitcoin or portion of a Bitcoin or otherwise comes to hold Bitcoin, he or she must record its fair market value. Then, when the Bitcoin or portion thereof is transferred to another, the fair market value should be recorded again. The change in value is used to compute the gain or loss realized. While capital gains taxes apply to Bitcoin transactions, savvy individuals can minimize this tax by working with a tax professional who can determine and apply the accounting method most likely to produce favorable results.
When filing taxes, a taxpayer will be expected to provide adequate documentation supporting his or her calculations. A failure to keep and provide records could lead to facing penalties under IRC Sections 6721 and 6722. A failure to calculate capital gains can also lead to accuracy related penalties under 26 U.S. Code § 6662 – Imposition of accuracy-related penalty on underpayments. In scenarios where it appears that the taxpayer is willfully engaged in systematic tax fraud, the IRS is likely to refer the matter to IRS CI for work-up to criminal prosecution. In situations like these, the Bitcoin trader could even face felony tax evasion charges carrying a federal prison sentence.