Virtual currencies, also known as cryptocurrencies, have gone mainstream. For example, you can use Bitcoin to buy a Tesla, or you can use a Bitcoin wallet on your smartphone to make everyday purchases. But beware: Using virtual currency has federal income tax implications that may surprise you.

With increasing market acceptance and the skyrocketing price of Bitcoin, virtual currency has become an IRS hot-button issue. Here’s an overview of the tax rules that apply to this blockchain-based method of payment.

What is Virtual Currency?

Virtual currency is “digital money” that’s usually issued and controlled by software developers and accepted as payment by willing parties. Virtual currencies can be transferred, stored, held for investment, or traded electronically.

Unlike familiar conventional currencies, virtual currencies aren’t issued by government-controlled central banks. Though they’re not regulated by the government, every virtual currency transaction is recorded in a distributed, public ledger known as a blockchain. And anyone can download a copy of the blockchain to trace the path of virtual currency transactions.

Virtual currencies have an equivalent value in real currencies, such as U.S. dollars or Euros. The most common ways to obtain Bitcoin are through virtual currency ATMs or online exchanges, which may charge nominal transaction fees.

A key reason merchants accept virtual currencies is to avoid transaction fees charged by credit card companies and online payment providers, such as PayPal. Virtual currencies are also popular in foreign countries, such as Argentina and Iran, where national currencies are susceptible to inflation, corruption, government controls, or international sanctions.

Bitcoin is the most well-known example of a virtual currency. The supply of Bitcoin is capped at 21 million units. Because there’s limited supply, some people hold Bitcoin for investment purposes, hoping that they’ll appreciate in value over time. The Financial Industry Regulatory Authority (FINRA) warns that Bitcoin is highly speculative, and investors shouldn’t invest more in Bitcoin than they’re willing to lose.

Tax Basics

The IRS takes the position that virtual currency is “property” for federal income tax purposes. That means you’re supposed to recognize and report taxable gain, income, or loss every time you exchange virtual currency for goods, services, U.S. dollars, or for a different virtual currency.

Depending on the circumstances, a virtual currency holding can be classified as business property, investment property, or personal-use property. If you fail to report virtual currency transactions on your tax return and get audited, you could face interest and penalties, and even criminal prosecution in extreme cases.

Recordkeeping Requirements

Detailed records are essential for compliance with the federal income tax rules. Your records should note:

• When the virtual currency was received,
• The currency’s fair market value (FMV) on the date you received it,
• The currency’s FMV on the date you exchanged it,
• The virtual currency trading exchange that you used to determine FMV, and
• Your purpose for holding the currency (business, investment, or personal use).

This information is needed to determine the federal income tax consequences of your virtual currency transactions.

Reporting Virtual Currency Transactions

The 2020 version of IRS Form 1040 asks if, at any time during the year, you received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. The fact that this question is prominently displayed on the first page of your return indicates how serious the IRS is about enforcing compliance with the applicable tax rules.

IRS instructions clarify that reportable virtual currency transactions include:

• The receipt or transfer of virtual currency for free (without having to pay),
• The exchange of virtual currency for goods or services,
• The sale of virtual currency,
• The exchange of virtual currency for other property, and
• The disposition of financial interest in virtual currency.

To arrive at the federal income tax results of a virtual currency transaction, the first step is to calculate the FMV, measured in U.S. dollars, of the virtual currency on the date you receive it or pay it. The values of the most popular virtual currencies are listed on exchanges. For example, Bitcoin and three other virtual currencies are listed on the Coinbase exchange.

When you exchange virtual currency for other property, including U.S. dollars or a different virtual currency, you must recognize either:

• A taxable gain if the FMV of the property you receive exceeds your basis in the virtual currency that you exchanged, or
• A loss for tax purposes if the FMV of the property you receive is less than your basis in the virtual currency. However, various tax-law limitations may apply to virtual currency losses.  

If the virtual currency was held for investment purposes for more than one year, any gain will qualify as a lower-taxed long-term capital gain.

For example, let’s say you use one Bitcoin to buy tax-deductible supplies for your business. On the date of the purchase, Bitcoin is worth $60,000 each. So, you have a business deduction of $60,000. But there’s another piece to this transaction: the tax gain or loss from holding the Bitcoin and then spending it.

Suppose you bought the Bitcoin in January 2021 for only $31,000. So, you have a $29,000 taxable gain from the appreciation in value of the Bitcoin ($60,000 – $31,000) that you exchanged for the $60,000 worth of supplies. Assuming you’re not in the trade or business of buying and selling virtual currencies, the $29,000 gain is a short-term capital gain, because you held the Bitcoin for less than a year.

Virtual Currency Payments to Employees and Independent Contractors

If you use virtual currency to pay employee wages, the FMV of the currency counts as wages subject to federal income tax withholding, FICA tax and FUTA tax. Like any other wages paid to employees, you must report wages paid with virtual currencies on Form W-2.

If you use virtual currency to pay an independent contractor for performing services for your business, the FMV of the virtual currency paid is subject to self-employment tax for the contractor. You’re required to report the payment on Form 1099-NEC if payments to that contractor during the year amount to $600 or more.

You may also have a tax gain or loss due to appreciation or decline in the value of the virtual currency during the time you held it before paying it to the employee or independent contractor. Assuming you’re not in the trade or business of buying and selling virtual currencies, the gain and loss will be a capital gain or capital loss (short-term or long-term depending on how long you held the virtual currency).

Virtual Currency Receipts

If you accept virtual currency for goods or services, you must determine the FMV of the currency on the transaction date to convert the deal into U.S. dollars. Then you can calculate your taxable income or gain.

To illustrate, let’s say you sell a valuable vintage auto that you bought and restored for two Bitcoin. On the date of sale, each Bitcoin is worth $55,000. Your tax basis in the vintage auto is $57,000. How would you report this transaction on your tax return?

First, you would convert the two Bitcoins into U.S. dollars ($55,000 × 2 = $110,000). Second, you would calculate your taxable gain on the sale ($110,000 – $57,000 = $53,000). This is the amount you’d report as income or gain on your Form 1040.

Now, test your understanding with this example: Arnie is a self-employed IT professional who operates as a sole proprietorship for tax purposes. He accepts two Bitcoin as payment for a major project. On the date of receipt, each Bitcoin is worth $60,000 each according to the Coinbase exchange. How much income should Arnie report?

The answer is surprisingly simple: Arnie must recognize $120,000 of taxable income ($60,000 × 2) for services rendered. Because he’s a self-employed independent contractor, the $120,000 is also subject to self-employment tax. His tax basis in the two Bitcoin will be $120,000 when he uses it in a future transaction.

Ask the Experts

Many taxpayers may be unaware of all the federal income tax implications of virtual currency transactions. But the IRS doesn’t usually accept ignorance as an excuse for failure to comply with tax rules. There may be state income tax consequences, too. If you have questions or want more information, contact your tax professional.