Even if you are not technically savvy, you have probably heard of Bitcoin. Bitcoin is the most well known in a growing field of virtual currencies.  But what is virtual currency?

The IRS describes virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.  Some virtual currency has an equivalent value in real currency, or acts as a substitute for real currency. This is referred to as “convertible virtual currency” since it can be digitally traded between users and can be purchased for or exchanged into U.S. dollars, Euros, and other real or virtual currencies.

Cash or Property?

If it can be traded for other currencies, is it considered cash?  Not according to the IRS, who ruled that virtual currency is to be treated as property for tax purposes.  General tax principles that apply to property transactions also apply to transactions using virtual currency.  But what does this mean?

Determining Value:  For U.S. tax purposes, you will need to determine the value of your currency in U.S. dollars.  You need the value as of the date you receive or make a payment.   If the currency is listed on an exchange this should be easy, since the exchange will list the value of the currency as of any particular date.  Historical values of Bitcoin can be found online at CoinDesk.  Bitcoin’s value has seen wide fluctuations, and changes daily based on supply and demand.

Gain or Loss in Value: The value of virtual currency will fluctuate with the market.  Just like stocks and bonds, the gain or loss is not considered taxable until the item is disposed of.  When you use virtual currency to pay for something, this is, in effect, disposing of your currency.  You will have a taxable gain or loss when this happens.  This will make record keeping tedious, because this means the fair market value of your virtual currency will need to be tracked each and every time it is used.   This is true even if the transaction was not for business purposes.

Example:  I purchase a non-business computer priced at $400 using virtual currency.  This $400 worth of virtual currency was only worth $50 when I received it, but the value was $400 (the value of the computer I received) when I disposed of it.  I now have a capital gain of $350 to report.

This brings up another interesting scenario.  If you are conducting transactions in virtual currency, you will likely have units of the currencies with different basis (the value of the currency when you received it).  If you are purchasing something with these currencies, consider which actual units you use in the transaction.  In the example above, if I had different units of virtual currency worth $400 that was worth $300 when I received it, my capital gain would have only been $100.

Sales Taxes:  The California Board of Equalization has issued Special Notice L-382 to address virtual currency.  The notice confirms that anyone accepting virtual currency must consider sales and use tax for these transactions, using the same rules as for cash or credit card payments.  The sales tax is calculated on the normal cash sales price, and not on the value of the virtual currency received.

Consider that the IRS has labeled virtual currency as property for tax purposes.  Does this mean that the virtual currency itself will be subject to sales tax, since any transaction made with it will be a property transaction?

Payment for Goods or Services: If you are paid in bitcoin, or other virtual currency, this will be treated as income to you.  The amount of income depends on the actual market value on the date you receive the payment.  This would be handled on your tax return the same as if you had received cash for services.  The only difference is that the value of the virtual currency, on the date received, is used in determining the amount of income to report.  This is true even if the value of the currency decreases before you actually prepare your tax returns.

Payments are subject to the same withholding and reporting requirements as if you were paid in cash.  Wages paid in virtual currency are subject to federal income tax withholding and payroll taxes.  Payments to independent contractors that meet the threshold will be reported on Form 1099.

You can see there is much to consider about virtual currencies.  They are a new offering that does not quite fit the mold of cash or investment, but they are becoming more common.  If you are using Bitcoin or another virtual currency, make sure you understand the tax implications, and stay current on how the rules may change while the world is adjusting to this new method of making financial transactions.