IRS' Will Treat Bitcoins Like Other Forms of Property

The IRS' announcement Tuesday that it would treat Bitcoins and other virtual currencies like other common forms of property for tax purposes is a boon for investors, but attorneys say individuals using the currencies to pay for everyday items potentially face additional tax liability.

The ruling takes effect immediately and failure to comply will result in fines. However, the agency says it will allow leniency for failure to file in the past if there is "reasonable cause." (Presumably the absence of a rule would qualify.)

Experts say Tuesday's notice failed to address the tax and reporting burdens that will now apply to simple retail transactions that use virtual currency or how users should establish the currency's value. While the value of both types of assets can rise and fall, the tax rates are pretty different. Generally speaking, you'd pay the ordinary tax rate on the sale or exchange of Bitcoin held as a tangible asset--say you were paid in it. By contrast, you'd pay the lower capital gains rate of about 15 percent to 20 percent on transactions for Bitcoin held as an investment, for example if you obtained it on an exchange.

Virtual currency owners who regard their holdings as an investment will be happy to know they can now take advantage of the capital gains tax, which allows investors to pay a much lower percentage on holdings sold after a year and also deduct up to $3,000 in losses. But those who use Bitcoin and other virtual currencies as an actual medium of exchange may be encumbered by the additional paperwork.

Virtual currency sellers are not eligible for capital gains. Virtual currency miners will report their earnings as taxable income, and will be subject to payroll taxes if they mine as part of a business. If your business, or part of your business, mines and trades Bitcoin, you'll be liable for self-employment taxes on earnings. And if you're paying your employees in Bitcoin, the IRS says that pay is now subject to withholding taxes based on the virtual currency's fair market value.

Bitcoin advocates have noted that compliance relies heavily on the participants of the industry.  If bitcoin exchanges are ever required to provide trading results to the IRS like stock brokers are, then the IRS will have a record of your transactions. At that point you’ll be required to file all of it. Until then it’s pretty much just as you said.