When do I have to pay taxes on bitcoin?

Earlier this week, Elon Musk suggested Bitcoin and other cryptocurrencies were “clever” and a plausible replacement for cash. While an endorsement from a genius, billionaire is interesting, virtual currency is still hardly legal tender.

When a currency is legally recognized by a government to be valid for meeting a financial obligation, it is called legal tender. Coins and banknotes are usually defined as legal tender in most countries. Legal tender is backed by a central government, and the government controls the supply.

Bitcoin and other virtual currencies are not legal tender and they are not backed by a central government or bank. They are decentralized and are global.

For federal income tax purposes, transactions using virtual currency must be reported in U.S. dollars. You will be required to determine the fair market value (FMV) as of the date of payment or receipt of the virtual currency.

1. Virtual Currency Income Received
   
   Barter income. When you barter with someone you are exchanging one good or service for another without the payment of money. Barter exchanges are common in virtual currency exchanges. Currently, no record of barter exchanges are kept by any reporting agency. The FMV of virtual currency received in a barter exchange is subject to income tax as if it was U.S. dollars. When virtual currency is received in the course of a trade or business, the FMV of the virtual currency must be included in business income in the year of receipt and is subject to self- employment tax.
   
   Example: Jill has a cleaning business and cleans George’s house for a year in exchange for one bitcoin. The FMV of the bitcoin when received is $15,000. Jill recognizes $15,000 as business income on her tax return even though she did not receive any U.S. dollars.
   
   Employees. The FMV of virtual currency paid as wages is subject to federal income tax withholding, FICA tax, and unemployment taxes. It also must be reported on Form W-2, Wage and Tax Statement.
   
   
2. Virtual Currency Used to Purchase Goods or Services
   For federal income tax purposes, the main difference between using virtual currency to purchase goods or services versus the U.S. dollar is that virtual currency is treated as property. The tax basis of the U.S. dollar is its face value. When a product or service is purchased using the U.S. dollar, there is no gain or loss on the exchange of that U.S. dollar for the product or service. In contrast, the tax basis of virtual currency is the cost to acquire it. When a product or service is purchased using virtual currency, gain or loss is the difference between the fair market value of the product or service and the cost basis in the virtual currency that is exchanged for that product or service.
   
   Example #1: Brad uses two U.S. dollars to purchase a cup of coffee. Since Brad’s tax basis in those two U.S. dollars is their face value ($2), and the fair market value of the cup of coffee is $2, there is no gain or loss on the transaction.
   
   Example #2: Brad uses virtual currency to purchase a cup of coffee that is worth $2. Brad had previously acquired the virtual currency at an ATM machine by exchanging one U.S. dollar for the virtual currency. Brad has a $1 taxable gain on the purchase of the coffee, the difference between the fair market value of the coffee ($2) and the tax basis in the virtual currency ($1).
   
   
3. Mining Virtual Currency
   
   Miners. Mining is a process through which blockchain transactions are verified and accepted by adding such transactions to a blockchain ledger. Miners use computers to solve mathematical equations that are part of the encryption process. The first miner who solves the transaction and validates it receives a digital token of virtual currency as a reward.
   
   Gross income is realized upon the receipt of the digital token. The FMV of the virtual currency as of the date of receipt is includible in gross income. If you are in the trade of business of mining, the gross income is net earnings from self-employment and subject to self-employment tax.
   
   Hard fork. A hard fork occurs when a virtual currency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. A hard fork may result in the creation of a new virtual currency on a new distributed ledger in addition to the legacy virtual currency on the legacy distributed ledger. Following a hard fork, transactions involving the new virtual currency are recorded on the new distributed ledger and transactions involving the legacy virtual currency continue to be recorded on the legacy distributed ledger.
   
   ​Airdrop. An airdrop is a means of distributing units of a virtual currency to the distributed ledger addresses of multiple taxpayers. A hard fork followed by an airdrop results in the distribution of units of the new virtual currency to addresses containing the legacy virtual currency. However, a hard fork is not always followed by an airdrop.