Bitcoin Tax Checklist
- Written by Jason M. Tyra, CPA
By: Jason M. Tyra, CPA | Last year was very kind to Bitcoin. So kind, in fact, that for the first time, many previously casual Bitcoiners are finding themselves with substantial and unexpected gains to declare to the IRS. The good news is that taxpayers with Bitcoin activity to report are generally subject to the same rules and should enjoy the same deductions and credits as for other types of income. Here is a short list of special considerations that you can use as a checklist or as a starting point for a conversation between you and your client.
Decide how to file. Bitcoins received in connection with a trade or business or received as wages are subject to ordinary income treatment at the time received. Bitcoins held for less than a year prior to disposal may either be declared as short-term capital gains or foreign exchange gains, which also subjects them to ordinary income treatment. Bitcoins held longer than a year prior to disposal may either be declared as long term capital gains (with proper records) or foreign exchange gains. Since the IRS has issued no definitive guidance yet, taxpayers remain free to take the treatment of their choice for federal income tax reporting.
Consider whether your client might benefit from a request for a private letter ruling from the IRS. The IRS releases a list each year of tax issues for which it will not issue private letter rulings because they are currently in litigation, pending legislative action or under study. The latest list issued January 2 (see Internal Revenue Bulletin 2013-1) doesn’t mention Bitcoin, virtual currency, crypto currency or anything similar. This means that, for taxpayers with substantial gains to report, the time and expense associated with obtaining a letter ruling may be justified by the peace of mind gained by having one.
Consider theft and casualty losses that might have occurred during the year. In addition to being a year of tremendous gains, 2013 was also a banner year for Bitcoin thefts. In one particularly noteworthy incident, an unknown person or persons allegedly stole at least 96,000 Bitcoins from now-defunct Sheep Marketplace. A large number of Bitcoiners also lost money to frozen accounts (for various reasons, but mostly due to regulatory action) and failed exchanges. Finally, Bitcoins held in cold storage paper wallets or on crashed hard drives might have also been lost. Total, permanent, irreversible losses can be claimed to the extent of gains, as long as taxpayers can prove that the losses actually occurred. Theft and casualty losses can also be claimed as deductions independent of gains under certain circumstances.
Consider whether your client’s Bitcoin activity qualifies as a trade, business or as a hobby. In order to be considered a trade or business, an activity must have a profit motive. The IRS bases its profit motive determination during audits on a number of tests and other objective characteristics. For example, the IRS considers expectation of profit in at least three of five tax years to be a key factor in making this determination. If Bitcoin activity can properly be called a trade or business, then Bitcoin related expenses will most likely be fully deductible. However, business income may also be subject to self-employment taxes. If a hobby, then Bitcoin hobby expenses are deductible only to the extent of hobby gains. Net operating losses can be carried back up to five years and forward up to twenty years. Hobby losses cannot be carried back or forward.
Claim the applicable deduction for capital expenditures made during the year. Capital assets, such as Bitcoin mining peripherals and computers, must be depreciated over time, but may qualify for Bonus Depreciation or Section 179 treatment for 2013. These special provisions and others, collectively known as “tax extenders” expired at the end of 2013 and have not been renewed. For 2014 and later, lower limits on Section 179 expense and Bonus Depreciation remain in effect. Expenditures that exceed the lower limits must be capitalized and depreciated.
Don’t forget to include Bitcoin activity when calculating the net investment income tax. If your client is (un)fortunate enough to have modified adjusted gross income over the threshold amounts ($200,000 for single taxpayers, or $250,000 for those who are married filing jointly), Bitcoin gains may be subject to the net investment income tax. The statutory definition for net investment income includes interest, dividends, capital gains, rental and royalty income, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to a taxpayer. Bitcoin may fall into several of these categories, depending on your personal circumstances. Non-passive business income is not subject to the tax.
Declare foreign banking activity by filing a Foreign Bank Account Report (FBAR), if necessary. United States persons (citizens, residents and entities created in the United States) must file the FBAR if, at any time during the year, they had a financial interest or signature authority over a foreign financial account with a value of more than $10,000. A wallet with an exchange located in a foreign country, such as Mt. Gox, would cause the taxpayer to be subject to the FBAR rules. Note that the reporting threshold applies to your account balance on every day of the year, not the average balance or balance on just the last day. The FBAR threshold is also crossed when multiple foreign financial accounts have an aggregate value of greater than $10,000.
This list should serve as a starting point for addressing some of the most common Bitcoin-related tax issues and/or discussing them with your client. It is not all inclusive.