Bitcoins are all the rage lately. Proponents claim the online currency is safer than old fashioned "fiat money" issued by national central banks. Some people appear to agree and have been rapidly buying them up, leading to a speculative frenzy. Bitcoins that were valued at $5 a year were selling for as much as $260 in early 2013 before they fell back down below $100. Some speculators have been making real money off Bitcoins. Are the profits they earn subject to federal (and state) income tax? Of course they are.
What Are Bitcoins?
Bitcoins are an online digital currency created at a predetermined rate via an open source computer program that began running in 2009. There are no paper Bitcoins. Each Bitcoin consists solely of a coded Internet address that can be stored in an online "wallet" created by each Bitcoin owner. Bitcoins are created by a process called mining in which computers are used to solve complex mathematical problems. Only a finite number of Bitcoins can be created.
Bitcoins are not backed or regulated by any government, central bank, or other legal entity. Thus, no one has to accept a Bitcoin as money. However, a growing number of merchants are accepting them. Meanwhile, people have been buying and selling Bitcoins for dollars on online exchanges--much like gold. The value of a Bitcoin in traditional currency like dollars is not fixed by a bank or anybody else and can fluctuate wildly on the online exchanges.
Bitcoins can also be directly transferred anonymously across the Internet. This can make the Bitcoin a cheap way to settle international transactions because there are no bank charges to pay or exchange rates to deal with. Bitcoins are also an attractive way to purchase illegal goods or launder illegal money.
Some claim Bitcoins are safer than traditional currency because the currency's value can't be manipulated by central banks or governments.
Taxes on Bitcoin Profits
The IRS has not addressed the tax ramifications of Bitcoins, although--given their growing popularly--it may do so soon. However, applying normal tax rules, it is clear that Americans who trade in Bitcoins are subject to income tax on their gains.
Gross income--that is, income subject to tax--is very broadly defined by the Tax Code to include all income from whatever source derived. Income includes any "accession to wealth." Thus, if you purchase a Bitcoin for $100 on an online exchange and then sell it for $200, you have a $100 gain that is income subject to income tax. No bank or other third party is going to report your gain to the IRS. Still, it is your duty to report it and pay tax on it. If Bitcoins are treated as a commodity--like gold or silver--the "cash out" income from buying and selling Bitcoins would be taxed at capital gains rates for commodities--currently 28%.
A person who qualifies as a dealer in Bitcoins--that is, he or she is in the business of trading them--would treat any personal gains as business income taxed at ordinary income tax rates.
People who provide services or sell goods in exchange for Bitcoins also obtain taxable income--just as they would if they sell goods or services for gold or Euros. Their taxable profit is the value of the Bitcoins they receive (converted to dollars) minus the cost of the goods sold.