For those not familiar, Bitcoins are the first successful attempt to create an internet-based, “crypto currency.”  They are not regulated by a central agency or even completely traceable by a third party.  They are transferred on peer-to-peer networks and secured on servers.  People who mine, purchase or trade Bitcoins keep them in a “cyber wallet” from which they can then trade them.  Bitcoins can be traded on a barter system or sold for actual currency.  As of May, each Bitcoin was worth about $125 USD.

So by now you must be wondering if Bitcoins considered actual “currency”?  More importantly, are they taxable by the IRS?! 

If the IRS were to consider Bitcoins as a currency they would be subject to every tax law that other forms of legal tender are.  On the other hand, the Financial Crimes Enforcement Network (FinCEN), an arm of the US Treasury, had defined Bitcoins as “virtual currency”.  This means that they are a “medium of exchange that operates like currency in some environments, but it does not have all the attributes of real currency.”

But, to date, the IRS has not passed any guidance or regulation of their own on Bitcoins. 

As for taxing Bitcoins, any entity that you exchange as a payment for a good or service is considered “taxable income.”  This is true in all cases of bartering or trading.  Bitcoins would be considered a part of a person’s gross income and therefore included in their income tax liability to the IRS each year.  A trade between people does technically have tax consequences and should be acknowledged by the filing of a Form 1099.  Robert W. Wood, a reporter at Forbes, wrote in an article last month on Bitcoins that he believes there must be some sort of Form 1099 to track the trading of Bitcoins for either goods or services.

For people who exchange Bitcoins for legal tender, you would have to calculate your profit based on how much Bitcoins were on the day that you mined them less the value that you received when selling them.  This would then be considered income and, again, subject to the income tax.  For example, let’s say you bought a block of 25 Bitcoins that you bought at a market price of $30 per Bitcoin in June 2011.  If you then sold this block in April 2013 when the price reached $266 per Bitcoin, you would make a profit of $5,900.  This amount should technically be added to any other income you made that year and then taxed at the correct tax rate by the IRS.  If you happen to be a particularly unlucky person, the profit you made on Bitcoin exchanges could even push you into the next tax bracket.

There may be hope for Bitcoin collectors, however.  You just need to look back at IRS precedent on similar issues.  In 2002, the IRS issued a statement that they would not be taxing Frequent Flier miles because of the “numerous technical and administrative issues relating to these benefits.”

The ability for the IRS to track a person’s transfers of these Bitcoins is the real issue at hand.  Since Bitcoins are crypto currency they are not easily tracked since there is no central regulator.  The system of servers that keep an updated ledger for tracking Bitcoin mining and usage do not identify the people’s identities.  Like I mentioned earlier, Bitcoin miners have a digital wallet, which they have a “key” to.  The ledger will record the wallet which the Bitcoins are in, but not the identity of who owns the wallet.

Also, like many trading or bartering deals in the US, it is easy to keep Bitcoin trading under the radar of the IRS.  If a Form 1099 is not filed, then the only way for a person to be “caught” is a traditional IRS audit.  In that case, I would strongly suggest that conservatives take care to report all Bitcoin transactions!