Virtual currencies and related transactions are gaining popularity, but many tax practitioners are confused about their proper reporting and tax consequences. Despite the recent upsurge in virtual currencies such as bitcoin (BTC), the IRS has not issued comprehensive guidance on reporting requirements. Information in this article is based on the general guidance provided by the IRS in March 2014 in Notice 2014-21 and the application of general tax rules. This article describes a few key aspects of virtual currency phenomena, their tax ramifications, and what tax practitioners need to know about them.
What is virtual currency?
In simple terms, currency is anything that has an attributed value and is commonly accepted as a medium of exchange in an economy. Traditional currencies such as the U.S. dollar and the euro have a physical component (paper or coin). In contrast, a virtual currency is an entirely digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. It is not controlled by any government (decentralized). It can be used to pay for goods or services and/or held as an investment. Virtual currencies, also known as cryptocurrencies and digital currencies, are typically stored in digital "wallets," not in traditional banks.
"Convertible" virtual currencies have an equivalent value in real currency and act as a substitute for real currency. (1) The most commonly known convertible virtual currencies are BTC, ethereum (ETH), and litecoin (ETC). Nearly 2,000 virtual currencies exist, and more are being created.
How virtual currency is created and circulated
In general, many virtual currencies must be "mined" by powerful computers that solve complex mathematical algorithms, verify transactions, and group them into blocks on a blockchain. On the bitcoin blockchain, miners that submit blocks accepted by a consensus of nodes are rewarded with newly unearthed bitcoins. Large-scale miners house commercial mining computers in facilities called "mining farms." These are warehouses with thousands of computers mining for various virtual currencies and are often located in China or Southeast Asia, where operating costs are low. Mining can also be done on any consumer-grade computer at a home or office but will not be cost-effective due to low processing power.
Blockchain technology, the underlying platform for virtual currencies, facilitates their creation and is a system of worldwide distributed ledgers that record all cryptocurrency transactions in a series of cryptographically sealed blocks verified by a network of computers, or nodes. The technology underlying the blockchain helps make transactions written to the blockchain virtually impossible to alter after the fact. Well-known blockchains include the bitcoin network, ethereum network, Ripple consensus network, and Hyperledger. They offer different functionality and facilities. For example, the ethereum network processes transactions faster than the bitcoin network and allows peer-to-peer smart contracts and app creation.
In simple terms, a blockchain transaction can be summarized as: When Payer A sends virtual currency to Payee B, the transaction enters the blockchain as a cryptographic string of characters. Then, it is solved by a third-party independent miner to verify the amount, legitimacy, and accuracy of the transaction and the parties involved.
These currencies can be stored in digital wallets for appreciation. Also, they can be traded on third-party exchanges similarly to stocks. Exchange prices are determined by supply and demand similarly to foreign currency and stock markets. Trading platforms...