The wild west of bitcoin and other cryptocurrency taxes

It is an understatement to say that bitcoin and other digital currencies have taken the world by storm. Some of the valuation spikes -- from a few dollars to over $6,000! -- might make you think of the gold rush of yore. Still, what about the taxes? If you are one of the legions of people capitalizing on the wild west of cryptocurrency, you might want to think about taxes.

In fact, since it appears that there are lots of sales (and lots of other transactions) not being reported, you might want to think about penalties and interest too. You might not agree with the IRS, but the IRS says cryptocurrency is property. The IRS made this clear in Notice 2014-21.

Thus, cryptocurrency isn't foreign currency, and it isn't domestic currency, regardless of how you use it. That means every time you transfer it, you might trigger gain or loss. That means taxes. Property trades are taxed to both sides, even if one party just wants credit for later.

Swapping one product or service for another is taxable, as the IRS explains at its Bartering Tax Center on its website. Earning trade or barter dollars through a barter exchange is also taxable income, just as if your product or service was sold for cash. Plumbing for dental work? The IRS taxes it. You name the swap, it's income to both sides.

Most swaps of property are taxable to both sides, just like sales for money. Both must report the fair market value of goods or services received on their tax returns. 1031 exchanges are exceptions, but they may not apply to swaps of cryptocurrency. Besides, there are detailed rules to consider. So, get some advice before you assume that any swaps might be tax free.

The fact that bitcoin and other digital currency is property doesn't mean that everyone holds cryptocurrency as a capital asset. If you are paid for services, that is ordinary income, and might even be wages. If you are a miner, you are earning ordinary income.

If you hold cryptocurrency and later sell, it whether you have capital gain or loss depends on whether it is a capital asset in your hands. For long-term treatment, you want to hold for more than a year. Keep good records too. And don't assume that everything is anonymous. The IRS is hunting digital currency users, using John Doe summonses to obtain data. The IRS is even hunting bitcoin user identities with software. The IRS has a Chainalysis software contract to identify owners of digital wallets. The IRS claims that only 802 people declared a capital gain or loss related to bitcoin in 2015!

This suggests that the vast bulk of bitcoin transaction were not reported, at least in 2015. But in 2017, there is more awareness, and more fear. The estimated value of the cryptocurrency economy is something on the order of $162 billion. With millions of transactions and the meteoric rise of bitcoin from under $100 to over $6,000 in just a few years, the IRS is gearing up.

Taxpayers with unreported income could face taxes, penalties, or even worse. Remember, the IRS used a John Doe Summons to get names of Swiss bank account holders from UBS, ultimately collecting over $10 billion in taxes and penalties. For now, the IRS cut its request for customer records from Coinbase to accounts with transactions over $20,000. But the IRS is clearly doing more data mining for digital currency users.

Consider employment taxes too. Wages paid to employees using virtual currency are taxable, and must be reported on a Form W-2. Plus, they are subject to withholding and payroll taxes. If you pay someone in property, how do you withhold taxes? If you pay an employee some cash and some bitcoin, you withhold plenty on the cash.

Payments to independent contractors are taxable, and payers must issue Form 1099. When you pay an independent contractor and issue Form 1099, you can't enter "1,000 bitcoin" on the Form 1099. You must value it in dollars as of the time of payment. Valuation swings can be brutal.

If you use bitcoin to buy a meal, that's a taxable transaction to both sides. In fact, currently, there's no deal too small to attract the IRS. But that could change. A bipartisan bill, the CryptoCurrency Tax Fairness Act, was introduced in the House by Rep. Jared Polis (D-Colo.) and Rep. David Schweikert (R-Ariz.). It calls for tax exemption for all transactions under $600. But it hasn't passed. Stay tuned.

Consider your tax returns, but consider FinCEN too. FinCEN, the Financial Crimes Enforcement Network, is part of the Treasury Department. The FinCEN rules say Bitcoin exchanges and Bitcoin miners should register as Money Services Businesses, and comply with anti-money laundering regulations. Given the pressures now facing financial institutions to hand over account holders, and to withhold and remit taxes, expect more from FinCEN and the IRS.

Can you make tax-free loans of bitcoin and other digital currency? Borrowers and lenders think of loans as non-taxable. There can be tax issues when loans are forgiven. Also, there may be interest income to lenders, and interest deductions to borrowers. Mostly, though, loans seem neutral from a tax viewpoint.

You might think that loans in bitcoin or other digital currency should be the same, but that's not clear. When you receive a loan in cash, everyone understands that you will pay the lender back with other money. But the same is not necessarily true with a loan of property. In general, if you want to avoid taxes, a loan of property should arguably require the return of the same property.

With loans of cryptocurrency, the parties probably intend the cryptocurrency lent to be treated as fungible currency. But a borrower may receive bitcoins and sell them, repaying the lender with other bitcoins, or with other forms of cryptocurrency. It's not clear if cryptocurrency loans will be taxed, but you consider getting some legal advice to try to protect yourself in your loan documents if you are either borrowing or lending cryptocurrency.

Enjoy the wild west!