Updated March 25, 2014 2:25 p.m. ET
The Internal Revenue Service said Tuesday that it will treat bitcoin and other virtual currencies like property, not currency, giving a potential boost to investors but imposing extensive record-keeping rules—and significant taxes—on its use.
The announcement in general was expected to be greeted favorably by the fledgling industry, and many had anticipated exactly this result. But the announcement also served as a reminder that new technologies often can’t avoid being subject to the old rules for long.
In a notice, the IRS said that it generally would treat bitcoin held by investors much like stock or other intangible property. If the virtual currency is held for investment, any gains would be treated as capital gains, meaning they could be subject to lower tax rates.
The top long-term capital gains tax rate is 20%, while the top ordinary income-tax rate is 39.6%, although add-on taxes often make both rates somewhat higher. But as capital investments, loss deductions from bitcoin often would be limited, whereas currency losses can be easier to deduct up front.
The IRS notice also made clear that many people involved in handling virtual currencies—and many transactions involving them—would be subject to the same extensive record-keeping requirements, and taxes, as other people and other deals.
Notably, use of bitcoin in a retail transaction typically would be a taxable “event” for many buyers, requiring them to figure out the gain they had made on the virtual currency—and eventually pay tax on it. Tax experts say that could come as a surprise to some investors. It also could put a damper on use of bitcoin for many retail purchases.
The IRS also said that bitcoin “miners”–including people who use computers to validate bitcoin transactions or maintain transaction ledgers—also would be subject to tax on payments received in bitcoin. “Mining” that constitutes a trade or business would be subject to self-employment taxes, the IRS said.
Other people who receive bitcoin for performing services—including employees as well as independent contractors—also would be subject to tax on the fair market value of the virtual currency, the IRS said. Employers typically would have to report wages on a Form W-2, and the payments would be subject to withholding and payroll taxes, the IRS said.
And in general, many bitcoin payments made by a business exceeding $600 in value—such as for rent, salaries, wages, premiums and compensation—would be subject to information reporting to the IRS and to the payee. Payments to independent contractors also would be taxable and subject to information reporting on Form 1099.
Also, dealers in bitcoin—much like dealers in other types of property—would be subject to different tax principles than individual investors, and their gains generally would be taxed as ordinary income. And businesses that agree to settle payments between merchants and customers would be required to report many payments.
The IRS also said taxpayers may be subject to penalties for failure to comply with tax laws. The notice also applies to prior years.
The IRS guidance targets a new crop of digital currencies used by a small number of merchants, consumers and investors. Bitcoin, the best-known of the group, is created using a computer process and can be exchanged for dollars online. All the bitcoins in the world were valued at about $7.25 billion on Tuesday afternoon, according to the CoinDesk price index.
Some bitcoin users adopted the technology because it isn’t backed by any country, but its growing popularity has brought the scrutiny of regulators. While other countries have outlawed bitcoin, U.S. regulators have generally said it must meet existing laws regarding money laundering, fraud and other issues.
The IRS offered clarity about the tax treatment of virtual currencies, but it also raised new questions. If bitcoin can be treated as an investment for tax purposes, for instance, should bitcoin exchanges be overseen by the Securities and Exchange Commission? The SEC and other agencies are still studying the matter, according to U.S. officials.
The IRS notice also shed little new light on the question of whether virtual currencies could become significant new mechanisms for tax evasion, and how the IRS would try to combat that problem if it arises.
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