Taxation of Convertible Virtual Currency, Part I: It’s Not Money

Taxation of Convertible Virtual Currency, Part I: It’s Not Money

Ecuador will soon be the first country in the world to have digital currency issued by a central bank. Although the new Ecuadorian currency won’t necessarily function like Bitcoin, Litcoin, Peercoin and Freicoin, or other common alternative currencies in the virtual marketplace, the increasing use of virtual currency worldwide is a trend that can no longer be ignored.

Many countries are beginning to clarify the tax treatment of virtual currency; this past March, the IRS released guidance in Notice 2014-21 on how transactions using convertible virtual currency will be taxed in the U.S.  Note that this guidance only applies to “convertible virtual currency,” that is, virtual currency that “has an equivalent value in real currency” or that “acts as a substitute for real currency.” This means that it can be traded digitally and either purchased by or exchanged to U.S. dollars or other real currencies.

Calculating gain or loss of convertible virtual currency

Borrowing the FinCEN definition of virtual currencies, the IRS decided not to treat these currencies like money, since they are not legal tender. The IRS opted instead to treat them like property with a basis and a fair market value, subject to capital gains and losses:

  • The basis of convertible currency is its fair market value on the date it was received, measured in U.S. dollars.
  • The fair market value of virtual currency is determined by converting the virtual currency into U.S. dollars or any other currency which can be converted into U.S. dollars in any manner that is reasonably and consistently applied.
  • Calculating capital gains and losses in convertible currency is done in the same manner as calculating gains and losses in the buying and selling of stock—there is a taxable gain if the fair market value at the virtual currency’s sale exceeds the taxpayer’s adjusted basis; there is a capital loss if the value is less at sale than at receipt. 
  • If the sale or exchange involves virtual currency that was treated by the taxpayer as a capital asset, such as stocks, bonds and other investment property, it is realized as a capital gain or loss. 
  • If the virtual currency was treated like inventory or other property held mainly for sale to customers in the taxpayer’s trade or business, it is not considered a capital asset and the taxpayer realizes ordinary gain or loss.

Tracking your basis and sale value

Tracking basis and value at sale is fairly straightforward for taxpayers dealing in convertible currency as an investment. For taxpayers who treat it like cash, it may be difficult to determine the basis and the holding period.

Learn more about taxation of virtual currency from our full-service San Francisco tax law firm

For more than 30 years, the attorneys at Moskowitz LLP have represented clients in tax matters before the Internal Revenue Service, California Franchise Tax Board, and other taxing agencies.  Our professionalism and knowledge of the tax code and how it is actually administered has earned us the respect of our colleagues and tax agents alike.  Contact our San Francisco office today for a consultation.

Part II of this series will focus on convertible virtual currency income from wages, self-employment income and mining activities.

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