The real kick in the teeth for U.S. Bitcoin taxpayers is in how the IRS will deal with fraud, theft and loss of their bitcoins. In short, Joe can expect to get horrific tax treatment from all directions when it comes to losses on now-defunct exchanges, even if those exchanges lost all of the gains he had made.
Most casualty losses that apply to Bitcoin are governed by Section 165 of the tax code. Any individual losses are subject to a $100 floor and are only deductible to the extent that the taxpayer has a total loss for the year that exceeds 10% of his total adjusted gross income. Let's say that Joe lost $20,000 worth of bitcoins in his Mt. Gox trading accounts, which included $10,000 worth of realized capital gains. In the event of theft or embezzlement, Joe would be entitled to claim a loss in the tax year that he discovers the loss - in this case, 2014. However, he would still be on the hook to pay $1,500 in capital-gains taxes on the gains he had realized in 2013.
Talk about horrible luck. Imagine how those with millions of dollars worth of lost gains must feel!
Unfortunately, it isn't clear at this point whether any of the "lost" Mt. Gox bitcoins have been stolen or are even unrecoverable. If there is a "reasonable chance of recovery," Joe might not even be able to write off his Mt. Gox loss this year. And given that more than 25% of the "lost" bitcoins at Mt. Gox were recently located, there appears to be such a "reasonable chance" of recovery. (I won't even bother going into the complexities of recognizing potential "Goxcoin" gains and losses.)
How about in the case of managerial incompetence? Can Joe consider his Mt. Gox deposits to be lost bank deposits? That, too, is unclear given that Mt. Gox was an unregulated Japanese exchange rather than a fully licensed U.S. bank. But if it were, Joe would have to make a special election to treat the loss as a personal casualty loss to have it treated as a "miscellaneous" itemized deduction. Otherwise, he would be limited to writing off the loss over several years as an ordinary loss, $3,000 at a time. Once again, you can see how brutal the tax treatment would be for those who lost much larger sums than Joe. Even with this tax-loss treatment, some wouldn't be able to write off the full magnitude of their losses in a natural lifetime.
And just when you thought it couldn't get worse - Joe couldn't, under any circumstances, write off the losses he incurred when he deleted the private keys to the 25 bitcoins he mined for himself earlier in 2013. (Much more on mining taxation and other topics in part two of this multi-part series on Bitcoin taxation.)
The Bottom Line
Everyone knew that IRS guidance would cause ugly consequences for Bitcoin, but this comprehensive guide to Joe Consumer's tax liability should give you a glimpse of the magnitude of the reporting problem that the IRS has created. It isn't a given that existing wallet-service companies will come up with a comprehensive solution this year, or even in the medium term, that can account for the widespread tax-reporting issues under IRS Notice 2014-21. However, it does open up a massive opportunity for new apps to emerge that can handle the painful complexities.
Despite the absence of those killer apps, the IRS has no sympathy. The agency announced there is a "lookback" period for all Bitcoin tax liabilities, which means that taxpayers will be subject to severe penalties if they avoid taxes in 2013 or any earlier years. If you are like the average Joe Consumer, it's time to call your tax attorney.
In part two of this tax guide, we'll look at the business-tax consequences of using Bitcoin. What requirements should independent contractors or employees expect if they are paid in Bitcoin? What about merchants that hold small Bitcoin balances? How should miners account for their rewards, expenses and capital expenditures?
How about Bitcoin service providers that count Bitcoin as "inventory"? Stay tuned.
Disclaimer: As with many IRS gray areas, the tax law which applies to Bitcoin is still evolving, and future alterations are likely. The content of this article should not be misconstrued as financial advice. Please consult with a qualified tax professional or financial adviser if you are unsure how to handle your personal Bitcoin-related tax liabilities.
The author owns some Bitcoin but does not have shares in any Bitcoin-related corporation.
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