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Friday August 22, 2014

Article of the Month

Donating Virtual Currency

Defining “Virtual Currency”

What is virtual currency? Virtual currency is best understood by highlighting the difference between virtual currency and real currency.

Real Currency

The term “real currency” refers to the coin and paper money of the United States (or of any other country) that is designated as legal tender and is customarily used to purchase goods and services. The U.S. dollar is designated as legal tender in the United States. Legal tender can only be issued by a national body that is authorized to do so. In the United States the national body authorized to issue the U.S. dollar is the United States Treasury.

Virtual Currency

In contrast, virtual currency is a digital representation of value that may be used to purchase goods and services from certain vendors that accept it as a medium of exchange. Virtual currency is not designated as legal tender in the United States. Therefore, virtual currency may function like real currency in that it is sometimes accepted as a medium of exchange, but it is not backed by the U.S. Government or state or local governments.

Convertible Virtual Currency

Convertible virtual currency is virtual currency that has an equivalent value in real currency. Bitcoin is an example of a convertible virtual currency since it can be purchased for and exchanged into U.S. dollars or other real or virtual currencies. Although Bitcoin has the largest market capitalization, there are many other virtual currencies including Litecoin, Peercoin, Freicoin, Gridcoin, Fireflycoin, Zeuscoin and many others.

Virtual Currency is Property

How is virtual currency treated for federal tax purposes? In Notice 2014-21, 2014-16 IRB 1, the Internal Revenue Service explained that virtual currency is treated as property. Therefore, the general tax principles that apply to transactions involving property apply to transactions involving virtual currency.

Fair Market Value and Cost Basis

The fair market value of virtual currency is determined by converting the virtual currency into U.S. dollars using the exchange rate on the date of receipt. The fair market value on the date of receipt becomes the taxpayer’s cost basis in the virtual currency. This method of determining fair market value requires that the virtual currency is traded on an exchange. If the currency is not traded on an exchange then the fair market value is determined by obtaining an appraisal.

Gain or Loss

If the taxpayer later sells the virtual currency, then he or she will have gain or loss depending on whether the fair market value on the date of sale is more or less than the taxpayer’s basis in the virtual currency. The character of the taxpayer’s gain depends on whether the virtual currency is a capital asset in the hands of the taxpayer. If the virtual currency is a capital asset and has increased in value since receipt, then the taxpayer will recognize capital gain upon sale. If it is not a capital asset then the taxpayer will recognize ordinary gain upon sale. The amount of capital gain or ordinary gain recognized will be the difference between the fair market value on the date of transfer and the taxpayer’s basis in the virtual currency.

Mining Virtual Currency

It will be easiest to explain mining by referring to the most common virtual currency, Bitcoin. Bitcoin is a convertible virtual currency that was created in 2009. The algorithm was created anonymously as an open source project under the pseudonym Satoshi Nakamoto. The creator(s) limited the total number of bitcoins that can exist under the current algorithm to 21 million. At present, more than 12 million bitcoins are in circulation. New bitcoins come into circulation through the process of “mining.”

The Mining Process

The process of mining begins by obtaining mining software. A prospective miner installs mining software onto his or her computer. By running the mining software, the mining computer tries to find a sequence of data (called a “block”) that produces a particular pattern when the Bitcoin “hash” algorithm is applied to the block. When a match is found the successful miner receives a bounty of bitcoins in his or her virtual wallet. As bitcoins are mined, the size of the bounty decreases and the difficulty of decrypting the next block increases. This increasing level of difficulty and decreasing bounty is meant to mimic the production rate of tangible commodities like gold. So, although there are already 12 million bitcoins in circulation, it is projected that at the current rate of discovery the final bitcoin will not be discovered until the year 2040. Early on it was possible for individual computers of average processing power to mine bitcoins. Now, only powerful computers or pools of computers are able to mine bitcoins in a way that is cost effective for miners.

Taxation of Miners

When a taxpayer successfully mines virtual currency, the fair market value of the virtual currency as of the date of receipt is includable in gross income. If a taxpayer’s mining activities rise to the level of a trade or business and are not undertaken by the taxpayer as an employee, then the net earnings constitute self-employment income and are subject to the self-employment tax.

Donating Virtual Currency

Under current law virtual currency is treated like property. As a result, donations of virtual currency will be treated like donations of property. In order to accept bitcoins a charity will normally create a Bitcoin account with a payment processor.

Substantiation and Appraisal Requirements

For gifts of virtual currency over $250 in value, the charity must provide a contemporaneous written acknowledgment (i.e., a receipt). The receipt should describe the gift and explain that no goods or services were given in exchange for the gift. If goods or services were exchanged then the receipt should state the value of those goods or services and should reduce the gift value by that amount.

For gifts of virtual currency over $5,000, the donor must obtain a qualified appraisal. In order for an appraiser to be qualified, he or she must be certified by a recognized organization or have met comparable education and experience requirements (i.e., completed college or professional level coursework and have two years of experience in buying, selling or valuing the type of donated property). In addition, the appraiser must regularly perform and be paid for appraisals and must not have been prohibited from practicing before the IRS or excluded by Treasury regulations from serving as an appraiser. Since virtual currency is a fairly new medium of exchange it may be difficult to find a qualified appraiser.

The requirement to obtain an appraisal attaches when the value of all “similar items of property” given in the same taxable year exceeds $5,000 (whether or not given to the same charity). For example, if a person donates $2,000 in bitcoins to each of three different charities in the same taxable year that person must obtain an appraisal. The total value of bitcoins donated was $6,000, which exceeds the $5,000 threshold requiring an appraisal.

Deduction Limitations

The charitable deduction limit that applies to a gift of virtual currency depends on (1) the length of time the donor held the virtual currency and (2) whether the virtual currency was considered a capital asset or an ordinary income asset in the hands of the donor. If the property was held for more than one year and was a capital asset in the hands of the donor, then upon donating the property the donor may take a fair market value deduction up to 30% of the donor’s adjusted gross income (AGI) in the year of the gift. If the property was a capital asset in the hands of the donor but was held for less than one year, then the donor may only take a cost basis deduction up to 50% of the donor’s AGI in the year of the gift. If the property was ordinary income property in the hands of the donor then the donor can take a cost basis deduction up to 50% of his or her AGI in the year of the gift. The donor may carry forward any deduction that cannot be taken in the year of the gift for up to an additional five years.

Charitable Remainder Trusts

Contributing virtual currency to a charitable remainder trust is similar to contributing stock or land to a charitable remainder trust. The primary issue is valuation. If the virtual currency is not traded on an exchange then the donor must obtain an appraisal to determine the value of the currency donated. The difference between the donor’s cost basis in the currency and the fair market value on the date of transfer constitutes gain and that gain will be bypassed upon sale inside the charitable remainder trust. The trustee of the charitable remainder trust should set up an account to accept the currency (such as a Bitcoin account). Once the currency is transferred to the trust then the trustee should sell the currency and reinvest the proceeds.

Charitable Gift Annuities

Transferring virtual currency in exchange for a charitable gift annuity is similar to transferring stock or land for the same purpose. If the virtual currency is not traded on an exchange then the donor must obtain an appraisal to determine the value of the currency donated. States regulate the issuance of gift annuities to their residents. Sometimes these regulations include a standard for reinvesting gift annuity funds. Many states have yet to determine whether virtual currency is an acceptable investment. Until official guidance is available, the best policy for charities is to sell the virtual currency as quickly as possible after receipt.

A Word of Caution: Market Volatility

Since virtual currencies are not backed by any government, the market for virtual currency is extremely volatile. Price fluctuations occur often and can be drastic.

For example, on May 19, 2014 the value of one bitcoin was $444.31. Fifteen days later on June 3, 2014 the price of one bitcoin had risen to $665.73. By June 25, 2014 the price had dropped again to $562.13. To minimize the risk that the donated currency will lose significant value while held by the charity, the currency should be sold soon after receipt.

Published August 1, 2014

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