Buying, owning and selling virtual currency is all subject to the IRS supervision and must be recorded and reported properly to avoid severe tax penalties.
1. Characteristics: Virtual currencies are treated as property, as opposed to currency for federal income tax purposes. As a result, basic tax principles applicable to property transactions also apply to Bitcoin transactions.
2. Gain and Loss: When selling virtual currencies, one must take into account the character (capital vs. ordinary), the holding period, and the basis of their virtual currency.
a. 1031 exchanges: While there is little guidance from the IRS on this issue, 1031 exchanges of virtual currencies are likely prohibited, and will be treated as taxable transactions for both parties.
3. Mining Virtual Currency: A tax payer who mines virtual currency will include the fair market value of the Bitcoin as ordinary income on the date received. Net earnings from a miner’s activities likely constitute self-employment income and are subject to self-employment tax.
4. Employers and Employees: Employers must report wages paid to employees in virtual currency on a W-2 form. Anyone receiving virtual currency as compensation for services must report it as income.
5. Upon Death: Virtual currency is included in an owner’s estate upon death and is passed on passes according to a Will or intestacy. The fair market value of the virtual currency will be included in the taxable estate and subject to federal and state estate taxes. Under Section 1014, similar to any other property, the basis of virtual currency for the new owner will be the fair market value as of the deceased owner’s date of death. If the value increased, the new owner will receive a step-up in basis.
6. Failure to file tax returns or to report taxable income: If a tax payer filed a tax return, but omitted more than 25% of taxable income, the statute of limitations to collect taxes increases from 3 to 6 years. If the IRS determines that a tax payer failed to file a return, filed an inadequate return, or filed a false return, the statute of limitations remains open indefinitely.
Contact us if you have any questions relating to estate implications of owning virtual currencies.