There's a Hidden Bitcoin Tax You Need to Know About

With bitcoins now trading above $7,000 a pop — up seven fold from the start of the year — there's greater attention than ever on the cryptocurrency and what you can do with it.

The everyday items you can buy with the digital currency have multiplied over the years. Overstock.com accepts them, for instance, so you can get all your furniture using bitcoin. You can pay for plane tickets and hotels with them through CheapAir. Or Xbox games and Windows apps via Microsoft. Or computers via Dell and electronics via Newegg.

You can even buy lunch at a Subway sandwich shop in Allentown, Penn. using bitcoin, or gain access to the VIP room of a “gentlemen’s club” in Las Vegas.

Beware, though: “All those transactions go into your tax return,” says Bryan Skarlatos, a lawyer who specializes in tax issues at Kostelanetz & Fink.

Skarlatos is sounding the alarm on the issue because few people realize that the Internal Revenue Service does not view bitcoins as a currency like the dollars in your wallet. Instead bitcoins are treated as "property," which means they're subject to capital gains taxes.

How Bitcoin is Taxed

Every time you purchase a sandwich or video game with the cryptocurrency, you’re essentially making two transactions: First, you are selling property (bitcoins) in the eyes of the IRS. And then you are using the proceeds of that sale to make a purchase (whether it's a sandwich or a credenza). And when property is sold, you must report the purchase on your tax forms.

If your bitcoins have appreciated in price since you first obtained them — and there's a great chance that they have — you’re subject to capital gains tax when purchasing an item.

For instance, imagine you bought a $3,500 bedroom set at Overstock.com using half a bitcoin (or 50 million "satoshis") that you purchased for $200 at the start of 2016. That represents a capital gain of $3,300. At the typical 15% long-term capital gains rate, that works out to a $495 tax hit.

Of course, if you spend appreciated bitcoin that you’ve held for less than a year, that would be considered a short-term gain, taxed at ordinary income tax rates that can run as high as 39.6%.

You’re technically required to list every purchase you made in any given year with bitcoins, outlining the capital gain or loss from selling the digital currency to make the transaction, “no matter how small,” Skarlatos says.

There's more: The capital gains hit would come on top of the sales tax that you would pay for the item you wind up purchasing, adding another fee to transactions using cryptocurrencies.

Ignore the IRS at Your Peril

While some may ignore the issue – only 802 people reported Bitcoin profits to the IRS in 2015 – it’s important to remember that transactions are stored permanently within bitcoin’s network. This means a motivated IRS could easily find every purchase someone makes.

On a larger scale, it’s another issue that can hold back the mainstream appeal of a tool like bitcoin. Complications such as this tax rule prevent it from growing as an everyday option for purchases. Ease of use gives bitcoins “value,” adds Skarlatos. The more difficult it is to use, the more bitcoins’ ultimate value suffers.

Representatives Jared Polis (D-Colo.) and Rep. David Schweikert (R-Ariz) have introduced legislation that would limit the reporting of purchases to anything above $600. It’s something that will likely be discussed as the efforts for tax reform move forward.

Until then, though, bitcoin users will need to have a way to report all the transactions throughout the year to avoid the IRS’s ire. Libra offers free software for individuals that links directly to an e-wallet, providing a spreadsheet of your transactions.

Or you can limit your spending with the currency, but there’s nothing wild about that.