As more people participate in bitcoin transactions, it is important for accountants and tax preparers to understand the various transactions and their appropriate taxation.
What is bitcoin mining?
Bitcoin mining is the use of specialized computers to solve hashes (algorithmic equations) on a blockchain. The miners (people who own the computers), are paid for solving the hash and if they are part of a pool they get a share of the reward when the pool solves a hash. Miners also receive a share of the transaction fees paid to process a bitcoin transaction. There are other digital currencies (cryptocurrencies) besides bitcoin and these are referred to as altcoins. The various altcoins also use a mining process.
How are the rewards and transaction fee income taxed in the United States?
For an individual, this income is taxed as ordinary income on a Schedule C. The amount of income is determined based on the exchange rate from bitcoin to U.S. dollars as of the day the miner receives the bitcoin payment regardless of whether the bitcoin is converted to dollars on that day.
Investing in bitcoin and other cryptocurrency
In addition to the miners who have earned bitcoin (or an altcoin), there are also investors who buy various cryptocurrencies to either trade or hold for their appreciation. I recently spoke to one investor who day-trades in cryptocurrencies and even takes advantage of variances in prices between exchanges. An exchange is an online software platform where traders can buy or sell cryptocurrency
in exchange for dollars or another cryptocurrency. The exchange is the intermediary between the buyers and sellers.
What happens when the bitcoin is converted to dollars or another cryptocurrency?
A U.S. individual taxpayer will be required to report either long-term or short-term capital gains or losses when they convert bitcoin to dollars. If an individual converts bitcoin to another currency such as litecoin and there is a gain/loss compared to the individual’s U.S. dollar basis in the coin as of the transaction date, then a gain or loss is reported. The litecoin’s basis becomes the U.S. dollar value as of the transaction date. There has been talk among investors that this is a like-kind exchange. Based on prior tax court rulings for coins and precious metals, it does not seem likely that like-kind exchange treatment will succeed on examination by the IRS.
If bitcoin is used to purchase a good or service, is there a taxable gain on any appreciated value?
Yes, using bitcoin that is worth more on the date it is spent than when it was purchased or earned creates income. So assume you bought your bitcoin (btc) at 1 btc = $1,000. If you use .10 bitcoin to buy a $1,000 couch on Overstock.com and the exchange rate is now 1 btc = $10,000, you will be obligated to recognize capital gain income of $900.
What if a taxpayer was holding bitcoin at the end of the year?
Holders of appreciated bitcoin not converted to dollars do not pay tax on the increase in value. Taxation only occurs when bitcoin is spent, converted to an altcoin or dollars.
The IRS has recently issued a summons to the cryptocurrency exchange, Coinbase, to obtain transactions over $20,000. The IRS is clearly going after those who have not reported their gains.
About the Author
Nancy Orben is a CPA and Senior Manager at Blue & Co. She is a Certified Bitcoin Professional and is the accountant and business advisor for a cryptocurrency mining operation. Nancy specializes in accounting software and related process improvement consulting for various industries including manufacturing, construction and non-profits.