Are you a bitcoin user or investor? The IRS wants to know

Last year was a momentous one for bitcoin. The cryptocurrency began the year at just under $1,000 and finished at just over $14,000, posting a whopping one-year gain of nearly 1,400 percent.

I can't say if bitcoin and other cryptocurrencies such as litecoin, ethereum, bitcoin cash and ripple make for good investments. Nor can I tell you how the huge run-up in the prices will end (though Warren Buffett said Wednesday: "I can say with almost certainty that they will come to a bad ending"). But I can provide a few answers as to how the IRS treats transactions using virtual currency.

First, the agency has acknowledged that virtual currency, such as bitcoin, may be used to pay for goods or services, or be bought, held and sold as an investment. In some transactions, digital money operates like the real money of the U.S. and can be used as a medium of exchange. 

The IRS also said virtual currencies don't have legal tender status, meaning you can't use one to pay your federal tax liabilities.

How does all of this apply to everyday transactions using cryptocurrency? Let's go through a few common examples.

Let's say you provided services to someone who paid using bitcoin. According to the IRS, a taxpayer who receives the bitcoin as payment for goods or services must include its fair market value as measured in U.S. dollars as of the date the virtual currency was received. If the total payments from a person to you were $600 or more for the year, the person making the payment is also required to report it to the IRS by issuing a Form 1099-MISC.

Now let's say you held the bitcoin you received as payment, and you also bought some more. After a spectacular rise in the price of your bitcoin, you decided to sell them and take your profits. 

The IRS will then expect you to report the gains you've realized. Generally, this is a capital gain (or a loss) when the virtual currency is a capital asset (held as an investment with an expectation of making a profit).

Your cost basis is the bitcoin's value in U.S. dollars on the date you received the payment and on the date you bought the additional coins. If you owned the bitcoin for 365 days or less, your gain is characterized as short-term and is taxed as ordinary income. The rate will depend on your income and can be as low as 10 percent and as high as 39.6 percent on your 2017 tax return.

If your bitcoin profit was the result of selling coins held for more than a year, the realized gains will be characterized as a long-term capital gain. That tax rate is as low as zero to as high as 20 percent. Most people will fall in the middle and pay a tax of 15 percent.

If you used bitcoin to pay for services or goods, it's possible you would have a gain on the coins you transferred for payment. The value of the goods and services you received should approximate the U.S. dollar value of the bitcoin on the date of the transfer.

One thing to remember when computing your gain on the sale of virtual currency is to include the transaction fees you paid when you bought and sold. Anyone using the popular site Coinbase know these fees can be significant. They're listed on the transaction history of their virtual currency wallet.

Don't expect virtual currency websites to send you tax-reporting forms such as a 1099 summarizing your transactions, gains and losses. Currently, the only IRS reporting requirements are for people who settle payments made in virtual currency on behalf of merchants, such as businesses known as third-party settlement organizations. They're required to report payments made to a merchant on Form 1099-K, when the number of virtual currency transactions exceeds 200 and the gross amount received by the merchant exceeds $20,000.

Most individuals who've made a few bucks buying and selling a few bitcoins or some other cryptocurrency in 2017 will have to rely on the honor system to get the information they need to calculate their gains and report it to the IRS.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.