A Bit About Bitcoins

Lately there has been a lot of buzz about Bitcoins. Their value recently went through a surge and then a correction, and lots of folks were wondering - what are they? How do they work? And most importantly, what are the tax implications of using Bitcoins? Bitcoin is a digital currency, described as a peer-to-peer, electronic cash system. Bitcoin creation and transfer is based on an open source cryptographic protocol and is not managed by any central authority. Each bitcoin is subdivided down to eight decimal places, forming 100 million smaller units called “satoshis.” Bitcoins can be transferred through a computer or smartphone without an intermediate financial institution. The processing of Bitcoin transactions is secured by servers called Bitcoin miners. These servers communicate over an internet-based network and confirm transactions by adding them to a ledger, which is updated and archived periodically. In addition to archiving transactions each new ledger update creates some newly-minted bitcoins. The number of new bitcoins created in each update is halved every 4 years until the year 2140 when this number will round down to zero. At that time no more bitcoins will be added into circulation and the total number of bitcoins will have reached a maximum of 21 million.Bitcoin is accepted in trade by merchants and individuals in many parts of the country. And if you think the IRS won’t get their piece, think again. The IRS already gets a piece where you swap one product or service for another, as the IRS explains at its Bartering Tax Center. Soon the IRS may have a Bitcoin Center too. The Treasury unit called FinCEN, the Financial Crimes Enforcement Network, already has rules about Bitcoin and the IRS is likely to follow.Income is income, whether you get it in cash or in kind. Bitcoin may be accepted as currency and may not be easy to trace but so are trades and barters. When you barter or swap one item for another, both parties have tax consequences. Earning trade or barter dollars through a barter exchange is considered taxable income, just as if your product or service was sold for cash. And even trades are still taxed. How will the IRS know about your swap? They probably won’t unless you receive a Form 1099. Still, the IRS says you must report any income on your return regardless of whether you receive a Form 1099.