Start with some definitions: what is “currency” anyway?

Currency is money in any form that is in use or circulates as a medium of exchange. Anything can serve as currency, and many things have, such as cattle, beads, gold, and these days, paper. The key is that it serves as a medium of exchange: you trade your currency for something, the seller can then take the currency and trade it for something else.

Legal tender is a currency that a government recognizes. These days legal tender is limited to coins and banknotes (and their equivalents in bank account balances). A central government backs legal tender, it is always accepted for meeting financial obligations, and the government controls the supply.

Virtual currency is not legal tender, and a central government or bank does not back it. But it is a store of value and a medium of exchange.

Since virtual currency is not legal tender, the tax code generally treats it as property. You buy and sell it using legal tender and realize a gain or loss that is taxed or offsets your tax.

The original modern virtual currency: barter exchanges

Virtual currency is not a new concept. Barter exchanges, groups that barter, have been around for many years and create their own medium of exchange. Call these barter dollars (they could be named whatever the exchange prefers).

Members of barter exchanges trade goods or services for barter dollars rather than US dollars. They use the barter dollars to buy other goods or services from other exchange members.

Barter dollars do not usually convert into legal tender (US dollars). Regardless the IRS considers them income. Their taxable value is the fair market value in dollar terms of the barter currency.

The new wave of virtual currencies: cryptocurrencies.

Cryptocurrencies are just another type of currency.

Anybody can decide to accept cryptocurrency in exchange for goods, services, or legal tender, whereas a barter exchange is a closed group. Bitcoin is the most popular cryptocurrency, but there are many others.

There is also a big difference in how these currencies come into being. In barter, the currency arises from the exchange: I do work for you; you pay me in barter dollars – the work creates the currency.

To create a cryptocurrency, miners “mine” by using computers to solve complex mathematical problems. As they solve these problems, they earn tokens.

The tokens are entries in a ledger, that you can trade or exchange for other goods, services, or legal tender.

(An aside: these problems are incredibly complex, so they take a long time and a lot of computing power to solve, mining bitcoin is expensive.)

There are some twists and complications to owning cryptocurrency that don’t arise with barter dollars or legal tender. (Hold on for the next couple of paragraphs, this gets techno-jargony)

The Cryptocurrency Ledger can be split into an action called a Hard Fork. Think of this as the creation of a new currency by splitting one ledger into two ledgers.

After a Hard Fork, the exchange distributes the new virtual currency units through an “Airdrop.”

Hard Forks and Airdrops matter because they bring up the topic of constructive receipt: you only own the virtual currency once you can exercise dominion and control over the currency or have “constructive receipt” of the currency. If a currency had a Hard Fork, but you never received the Airdrop, or your exchange doesn’t support the new currency then you have not received the currency, and it is not taxable.

In most cases, this is pretty simple: you buy Bitcoin, you trade Bitcoin, and you sell Bitcoin. But the topics of forks, drops, and constructive receipt can surface with more esoteric currencies.

Taxing virtual currencies

The tax code taxes all virtual currencies at their fair market value in dollars.

For example, Jill has a cleaning business and cleans George’s house for a year in exchange for 15,000 barter dollars. She would have otherwise sold these services for $15,000 – so the fair market value of the barter dollars is $15,000, and her taxable income is $15,000.

If Jill charges one bitcoin token (or fraction of a token) worth $15,000, her taxable income would still be $15,000.

If Jill changes her price for the virtual currency, then the income is distributed differently.

Imagine Jill only charges $10,000 in bitcoin or barter dollars but would typically charge $15,000. George pays in $10,000 barter dollars or the equivalent in bitcoin. In this case, Jill has a taxable income of $10,000, and George has a taxable gain of $5,000, the difference between what he paid and the fair market value.

Cryptocurrencies add the wrinkle of having an equivalent value in legal tender. In tax terms, virtual currencies are property. Therefore, you can incur a taxable gain. If George bought his bitcoin token for $1,000 and then paid Jill for $15,000 in services, he would have a $14,000 taxable gain (and Jill would still have $15,000 of income).

Keeping track of your currencies for tax purposes

If you buy and sell virtual currencies in an exchange, that exchange should track your gains and losses as you transact. They should send a statement to you at the end of the year to help you prepare your taxes.

Barter exchanges will also send you a statement of gains for you to report on your tax return.

However, tracking the fair market value of discounts can be more difficult. In the example above, George is responsible for tracking the excess value he received from Jill, declaring it and paying the tax.

In practice, the IRS is not going to track you down for small transactions. However, if you use virtual currencies often, you should expect some scrutiny and possibly an audit. So keep good records.

Keep in mind: the government backs no virtual currencies, and they are risky

There are four significant issues with virtual currencies:

The first issue with virtual currencies is that they can cease to exist at any time. They are an agreement that something is a medium of exchange. But just as beads and shells are no longer used as currency, barter, and cryptocurrencies could lose favor as well.

The second issue is that their value fluctuates. Our economy is legally denominated in US Dollars, and the value of a virtual currency can vary wildly in US Dollar terms over any given period. So if you use virtual currency you are subject to both price change risk and value risk.

The third issue with virtual currencies is that their use is limited. While these currencies are taxed like legal tender, you can only use them in certain situations. Everybody in the world either accepts US Dollars either directly or in exchange for another legal tender. You can only use barter dollars within a barter exchange, and very few places accept cryptocurrency.

Finally, calculating your tax burden is tricky and requires significant record keeping. Because of the fair market value taxation, using your virtual currency can open you up to hassles that legal tender does not.

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