It has been over three years since the Internal Revenue Service released guidance on the tax treatment of bitcoin and other virtual currency. Although the IRS made it very clear in Notice 2014-21 that virtual currencies are property for U.S. federal income tax purposes, there are plenty of questions that have been left unanswered. Considering that the IRS expects taxpayers to comply with federal tax laws and to treat bitcoin and other virtual currency thereunder, it is concerning that there are so many unanswered questions that could end up causing a taxpayer to inadvertently fail to comply with federal tax laws. Dealing for or in a virtual currency should prompt a consultation with a bitcoin and virtual currency tax attorney.
Valuation
One of the vague pieces in the guidance of Notice 2014-21 is specific information surrounding the valuation of virtual currency. The Notice requires that taxpayers value virtual currency in a “reasonable manner that is consistently applied”. Although seemingly easy enough, there is no official valuation authority for bitcoin and most other virtual currency. Instead, various websites across the internet update exchange rates throughout the day. A simple Google search can evidence the fact that each bitcoin valuation estimate varies from one website to the next, making it extremely difficult for a taxpayer to measure the value of their virtual currency at the time of its disposition. Furthermore, taxpayers have not received guidance as to whether averaging valuations can be an appropriate valuation manner.
Another consideration regarding valuation is timing. Notice 2014-21 does not indicate if there is a particular time of day that virtual currency should be valued at. The fair market value of a unit of virtual currency will need to be determined at least twice, once upon acquisition (to determine basis) and upon disposition (to compare with the basis to compute gain). Unlike other property with market values that tend not to fluctuate nearly as much as virtual currency, the time-of-day delineation is less of an issue. But with bitcoin, along with other virtual currencies, there can be a large fluctuation between the morning and evening.
Expenses Related to Acquiring Virtual Currency
Many virtual currencies, such as bitcoin, enter the market through the mining process. Said simply, powerful computers solve increasingly complicated mathematical equations (“mining”) that are used to authenticate the validity of outstanding virtual currency. In exchange for the calculations, the owner of the computer receives virtual currency. IRS guidance has been quiet as to how the costs associated with mining virtual currencies are treated from a tax perspective.
Generally, taxpayers that produce a piece of property include the costs to produce or to acquire it on the basis of the particular property. Thus, if the mining of virtual currencies were considered to be a production activity, taxpayers would include the costs of the mining operation on the basis of the virtual currency. Notice 2014-21 appears to treat virtual currency mining as a service activity as it states that gross income is realized at fair market value when the virtual currency is received. This guidance appears to treat virtual currency mining as a service activity whereby a taxpayer is rendering a service and receiving payment in virtual currency. Under such a service-based approach, costs related to mining would likely be expensed when incurred.
FBAR Inclusion
Foreign Bank Account Reporting (FBAR) laws require that Americans with foreign financial accounts with combined balances of $10,000 or more report the existence of those accounts to the government on a yearly basis. The IRS has indicated that even money that is not in foreign bank accounts may be subject to FBAR requirements if the requisite dollar amount is held in other types of accounts like online casino accounts based in a foreign country.
Although FBAR laws only apply to currency (and thus assumedly does not apply to virtual currencies), the IRS and Department of Justice have made a push to gain more insight as to who owns virtual currency, particularly bitcoin. The Department of Justice recently issued a “John Doe” summons to Coinbase, a virtual currency trading company. The summons demands that Coinbase turn over records of all of those who have bought or sold bitcoin. This action was undoubtedly taken for enforcement purposes. Whether the IRS and DOJ will begin to target owners of virtual currency for FBAR violations is yet to be seen, but one thing is for sure: the IRS is aware that taxpayers are not reporting dispositions of virtual currencies and they are actively taking steps to catch them. It may be only a matter of time until efforts are expanded to encompass foreign virtual currency holdings. Another area of concern is can bitcoin and other forms of virtual currency be 1031 exchanged in a tax-free manner.
Knowing When to Contact a Tax Attorney
The uncertain points about bitcoin and other virtual currencies described above are just a sampling of some of the issues that are unclear from a tax planning and compliance perspective. The tax code and corresponding regulations are comparable to a labyrinth wherein even the most informed taxpayer can become lost without the proper guidance. Dealing with or for virtual currency can create unexpected outcomes and without the proper guidance from an experienced tax attorney, has the potential of landing a taxpayer in a compliance nightmare. If you have bought, sold, or are dealing in a virtual currency, it is in your best interest to contact a tax attorney familiar with the subject matter as soon as possible.
The tax and accounting professionals at the Tax Law Offices of David W. Klasing have extensive experience in assisting taxpayers from all walks of life. From tax planning to defending against an audit or prosecution, our team of zealous advocates are ready to work diligently in your best interest. Don’t let the uncertainty of tax controversy cost you any more sleep. Contact the Tax Law Offices of David W. Klasing today for a reduced-rate consultation.
Here is a link to our YouTube channel: Click Here.
Here is a link to our practice overview video on warning signs that an audit has gone criminal.
