Virtual currency is a new, untested, and unregulated asset. The Internal Revenue Service (IRS) defines “virtual currency” as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. “Convertible virtual currency” is virtual currency that has an equivalent value in real currency, or acts as a substitute for real currency. For simplicity, this post will use the terms virtual currency and convertible virtual currency interchangeably. Virtual currency is held for investment, used to pay for goods and services, and traded through online exchanges. Bitcoins and Ripples are the most well-known types of virtual currency. Bitcoins and Ripples contain their own version of virtual currency and systems, including payment systems. A Bitcoin or Ripple is sent between two accounts, converted into other currency, or used to pay for goods and services. Both Ripples and Bitcoins are finite in number, with only a certain number existing. Virtual currency is volatile, with unpredictable swings in value.
A particular virtual currency’s long-term viability is questionable because virtual currency is far from “mainstream.” Few merchants accept virtual currency for payment. Virtual currency is unregulated and decentralized, meaning there is no bank or governmental oversight. Taxpayers, however, might have to report virtual currency held in foreign exchanges to the IRS. Although the accounts currently are not subject to Report of Foreign Bank and Financial Accounts (FBAR) requirements, commentators opine that, in the future, virtual currency accounts could be subject to FBAR and the foreign exchanges could be subject to reporting under the Foreign Account Tax Compliance Act. Virtual currency is subject to higher scrutiny by law enforcement agencies due to perceived abuses. In law enforcement’s view, because virtual currency transactions are largely anonymous, opportunities exist for money laundering and tax evasion.
On April 14, 2014, the IRS issued Notice 2014-21, which stated that the IRS treats virtual currency as property, and therefore traditional property rules apply. A transfer of virtual currency is treated as a sale or other disposition of property, and gains and losses realized are required to be computed as well as recognized, even when such transfer is used as a payment mechanism. In the IRS’s view, a taxpayer must track basis. A recent A.B.A. Probate and Property article — Comiter, Andrew, and Klein, Sasha, Bitcoin: Are You Ready for This Change for a Dollar?, A.B.A. Probate and Property, Mar./Apr. 2015 Vol. 29 No. 2 at 10 — provides an example of the accounting and tax complexities involved with virtual currency. If a taxpayer uses an appreciated Bitcoin to purchase goods, the taxpayer must determine the specific Bitcoin’s basis and holding period to determine the amount and character of gain recognized. Because the taxpayer used an appreciated Bitcoin (instead of cash) to purchase the goods, the taxpayer triggered a taxable gain, lost the step-up in basis at death (because the taxpayer disposed of the Bitcoin before death), and diminished the estate by the taxes paid on the gain. Absent from Notice 2014-21 is explicit guidance on estate and gift treatment. The sweeping statements “for federal tax purposes, virtual currency is treated as property” and “general tax principles applicable to property transactions apply to transactions using virtual currency” were apparently meant to also cover estate and gift treatment. The absence of estate and gift guidance is puzzling because the notice specifically addresses other topics such as self-employment income, wages, withholding, and even information reporting.
The IRS and the Treasury Department acknowledge that there may be questions that were not addressed in the notice. The IRS recently stated that Notice 2014-21 was not attempting to establish a new tax regime for virtual currency, but to draw an analogy to bartering transactions. In the private wealth context, because traditional property principles apply, a virtual currency gift recipient receives a carryover basis under IRC §1015, whereas an estate beneficiary receives a step-up in basis under IRC §1014. Virtual currency’s fair market value as of date or death or alternate valuation date would be included in a decedent’s estate for estate tax purposes.