There are virtual worlds out there, and also virtual currencies. Bitcoin has come up as the most well-known, traded, and used virtual currency thus far, so much so that it’s spiked the interest of governments and the IRS.

So what exactly is a virtual currency, a bitcoin, and how does the IRS treat them for tax purposes?

What is a Virtual Currency?

Virtual or digital currencies exist completely online so that people in virtual spaces can make transactions between one another (mainly in social and gaming environments). Unlike the US Dollar, there is no federal reserve that backs up their value (whether or not the fed backs up the US Dollar figuratively or literally is another topic entirely). Obtaining virtual currency can usually be done through either converting real currency into virtual currency on some sort of exchange system, or by completing certain tasks in order to earn them within a social/gaming environment.

Virtual Currency is also used as a way to make underground, illegal transactions with untraceable money (the most notorious being the FBI’s 2013 shutdown of the Silk Road website, an online drug marketplace where the bitcoin was the only currency accepted), snub governments and banks which are in control of the money systems, and potentially get around pesky banking fees altogether (like PayPal’s fee).

What is a Bitcoin?

Bitcoin was created in 2009 as a decentralized currency that you send person-to-person without a bank involved, and that you can use within any country. Within the realm of virtual currencies, it is a cryptocurrency because it uses cryptography to control the creation and transfer of money. And it’s the most successful attempt to date at creating a true virtual currency (failed attempts include the CyberCash, DigiCash, Beenz, Flooz, etc.).

Bitcoins are earned all over the internet by people using an application called a bitcoin miner. The software for mining is completely open source, allowing anyone to review and use the code (though apparently, it is very competitive). The generation of bitcoins is controlled so that there are only a select number of them available at any given time. Once you earn some, they will be stored in your digital wallet (discussed below).

The company Robocoin has created the first bitcoin ATMs where you can get cash for your bitcoins with your email, palm, government ID, face and cash. Three of these ATMs are set to be installed in the next few months in Austin, TX, and Seattle. And that’s not all; several traditional businesses such as Overstock.com and a few Subway sandwich shops have begun to accept bitcoins as payment.

Bitcoin Taxes

There are two different ways that you can obtain bitcoins: by “mining”, or in exchange for products, services, or other currencies. Since its inception in 2009, the price and exchange rate for bitcoins has changed dramatically, almost like a roller coaster ride (over $1,000, under $100, and back again).

Just recently, the IRS ruled that bitcoins will be treated as a capital asset (i.e. stock) when taxed instead of like a currency. This means that profits and losses will be subject to capital gains rules for US citizens. Yes, you will owe tax on Bitcoins.

Unfortunately, this means that each transaction done in bitcoins by someone will need to be tracked somehow. Mining bitcoins means that each one you receive or “earn” is now treated immediately as income. If you are buying and selling bitcoins as an investment, then you would calculate gains and losses the same as if you were buying and selling stock. And if you use bitcoins in a transaction (say, purchasing something off of Overstock.com), then in that transaction there is the opportunity for a gain or loss and it must be tracked. For bartering, normal reporting rules apply for independent contractors and self-employment tax.

Note: more rules on Bitcoin taxes are sure to come. In fact, it’s likely that the Treasury Department will need to come up with how to treat virtual currencies, which could have an impact on taxing rules.

How to Get Started

Interested in bitcoins? The first thing you will want to do is set up what’s called a bitcoin wallet (essentially a bank account) at blockchain.info. You will receive an account with a QR scan image and a long set of numbers/letters representing your public wallet address that you can give to others that you want to conduct transactions with. You will also receive a private key (like a password).

Have you heard of bitcoins? Know of anyone who is in the increasingly complex game of mining them? 

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