If your bitcoin stash is hacked, can you claim a loss on your taxes?
The short answer is yes, thanks in part to a February theft of 850,000 bitcoins that has prompted the Internal Revenue Service to weigh in on a “currency” that, in some cases, has become more ethereal than virtual.
A little background first: Bitcoins are a “peer-to-peer” payment system first introduced in 2009 as an alternative to cash and credit. While brief, the bitcoin history is sordid. Due to the anonymity provided to users— whoare identified only by a character string— bitcoins initially were used mostly for illegal transactions and money laundering.
Now, bitcoins are accepted by many mainstream businesses. There are even bitcoin ATMs that accept deposits, although they don’t dispense anything. Bitcoins may be purchased in exchange for currency, given for goods or services, or earned by “mining” or providing computer capacity to perform bitcoin transactions. Bitcoins are placed in “wallets” for safekeeping. Transactions are recorded across multiple servers and kept in a public register called the “blockchain.”
Bitcoins have gained considerable attention lately from communities as disparate as computer nerds, mainstream shoppers, computer hackers and even the IRS.
As bitcoins have grown in popularity, they have attracted more than 1,000 brick-and-mortar businesses and 35,000 online merchants that now accept bitcoins in the same way they accept traditional currency. However, growth has also attracted hackers and even prompted the IRS to weigh in on what bitcoins are.
The issue heated up in February, when 850,000 bitcoins worth an estimated $474 million were discovered missing from Mt. Gox, a large bitcoin exchange currently in bankruptcy proceedings. Though 200,000 bitcoins were found in March in an unused “wallet,” 650,000 bitcoins are still missing.
After this theft, the IRS felt it necessary to weigh in on bitcoins. The IRS ruling will impact how taxpayers report losses from hackers stealing bitcoins and how taxpayers should account for gains or losses from fluctuations in their price.
The questions the IRS would consider in its ruling were intriguing: Would bitcoins be respected as a new currency, as some kind of special property, or some new other designation?
The IRS provided its interpretation March 25 when it affirmed that bitcoins, like foreign currency held for personal use, were “convertible virtual currency,” but because they are not the legal tender of any country, they are simply treated as property for federal tax purposes. Think of it this way: People generally don’t keep a stack of Canadian dollars or Euros around for personal use purchases unless they intend to travel.
This presents a problem for bitcoin holders who do keep a bitcoin stash for personal use. Bitcoin values fluctuate more than most property. As a result of the IRS rules, bitcoin owners must — like holders of property or foreign currencies — keep track of every bitcoin purchase, sale or transaction, which may be fairly frequent.
For example, if Joe Smith deposits $500 into a bitcoin account that rises in value to $1,000 on the day he uses the bitcoins to buy a new guitar, Joe should report a $500 taxable gain on his next tax return. However, if the reverse situation occurs, and Joe deposits $1,000 and the value drops to $500 when he buys the guitar, he is not able to deduct a loss for the decrease in the value if it is personal property.
The IRS ruling has also taken all of the mystery out of treatment of stolen bitcoins: They should be treated as lost property. In technical tax terms, an involuntary conversion occurs when property is destroyed, stolen or condemned. Losses from involuntary conversions of personal property cannot be deducted unless the losses resulted from a casualty or theft. As a final insult, they can only be deducted to the extent the losses exceed 10 percent of your adjusted gross income. Ouch.
If you intend to get with the growing bitcoin wave, be careful of record-keeping requirements for gains and that bitcoin “wallets” pilfered by wandering hackers are subject to other unfriendly tax consequences. While taxes often rain on our parades, the rain on the bitcoin parade may be unseasonably strong with the latest IRS ruling.
Jerry Jonckheere is a partner in the Grand Rapids office of Plante Moran where he concentrates his practice on international tax issues. He can be reached at Jerry.Jonckheere@plantemoran.com.