Tuesday, June 18, 2013

Mining Bitcoins: A Taxable Event?

Bitcoins is an open source virtual currency that was developed in 2009 by an anonymous programmer.  Unlike dollars and other fiat currencies, bitcoins are not issued by any central government, but are instead "mined" by its users. 

Generally speaking, bitcoin miners download free software to solve complex equations that verify bitcoin transactions. When a miner’s computer solves an equation, the bitcoin network accepts the transactions as valid and creates 25 new bitcoins and awards them to the successful miner.  Around 11 million bitcoins have been mined, and there will be a maximum of 21 million bitcoins in circulation ever. In addition to mining new bitcoins, one can acquire existing bitcoins by purchasing them on third-party exchanges or accepting them as gifts or payments for goods or services.

It is fairly clear that when bitcoins are exchanged into dollars, the user has a taxable event to the extent that he (bitcoin users are 96% male) has gain from the transaction.  Likewise, someone who sells goods or services in exchange for bitcoins are subject to tax, in a manner no different than if he were paid in euros or chickens

A more difficult question is whether the bitcoin miner has taxable income at the moment when he receives the 25 newly mined bitcoins for solving the equations.  The United States Government Accountability Office (GAO), in a May 2013 report entitled Virtual Economics and Currencies [pdf], made the following statement:
 Bill is a bitcoin miner. He successfully mines 25 bitcoins. Bill may have earned taxable income from his mining activities.

The GAO provided no legal rationale for its statement, but it is probably based on the idea that Bill is being compensated for providing a service and that income is generally taxable unless a specific exception applies.  There is also some tax law stating that found treasure is taxable when it is discovered, even if the discoverer never sells the treasure for cash.  Treasury Regulation 1.61-14(a) provides that "Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession."

Even if bitcoin mining is a taxable event, the bitcoin miner can deduct an allocable share of his expenses from mining the bitcoins, such as the cost of the mining equipment and the electricity costs.

In comparison, small business miners of minerals generally do not have taxable income until they sell the mined products.  But the IRS will probably not be persuaded that bitcoin mining should be treated like gold mining.

A related issue is the Report of Foreign Bank and Financial Accounts (FBAR), which must be filed by all US persons with over $10,000 at any time during the year in foreign financial accounts, which includes securities accounts and commodities accounts.  If the US person transferred over $10,000 worth of bitcoins to a foreign bitcoin exchange, such as the Magic the Gathering Online Exchange based in Japan (and not an American branch of Mt. Gox), even for a brief moment, the person might have to fill out the FBAR and send it to the Department of the Treasury.  The penalties for not filing the FBAR can be especially severe. 

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