Cryptocurrencies have made some early adopters a lot of money, which—for conscientious taxpayers and tax professionals alike—begs the question: how does IRS handle Bitcoin and other virtual currency?

What is Cryptocurrency?

Cryptocurrency is a type of digital money backed by specialized encryption software. In the case of Bitcoin, that program is the blockchain. The goal outlined in the Bitcoin white paper was to eliminate the need for a “trusted third party” to handle electronic transactions by creating a peer-to-peer, digitally verified ledger, and this open-source program has already been the basis for many other cryptocurrencies.

For cryptocurrency to succeed as a currency, it needs to be widely accepted as a form of payment. Unfortunately, some of the largest markets in the world have begun taking steps to heavily regulate or even ban virtual currency exchanges, like South Korea and China. If you walk into a small-town-USA restaurant with nothing but Bitcoin on hand, you might as well try paying for that double cheeseburger with British pounds.

Even if US businesses begin accepting Bitcoin en masse, there’s another significant hurdle: IRS considers all virtual currency—Bitcoin included—as property for federal tax purposes.

What Happens if I Accept Bitcoin as Payment for a Good or Service?

IRS rules state that taxpayers who accept Bitcoin in exchange for a good or service have to include its fair market value on the date of receipt when computing gross income and basis. If you're an independent contractor exchanging services for cryptocurrency, IRS says to treat it as self-employment income.

What if I Keep Bitcoin as a Capital Asset?

Keeping Bitcoin or other cryptocurrency as a capital asset means that rules outlined in Publication 544 apply. Among the more obvious results of this ruling? Taxpayers will have to record capital gains and losses related to their cryptocurrency investment similar to a stock or bond.

What do IRS Rules Say About Mining Bitcoin?

It helps to first know what Bitcoin mining is.

Basically, a cryptocurrency miner dedicates a computer to completing a complicated math problem. The first person to solve it receives a number of bitcoins for their effort, while also verifying a “block” of transactions, and that signed block is added to the “chain” of previously verified transactions in the digital ledger—hence the “blockchain” portmanteau.

Now, how does IRS treat Bitcoin mining? Assuming the miner is not acting as an employee, 1) the taxpayer has to calculate the fair market value for bitcoins earned as a result of mining on the date of receipt for determining gross income; and 2) if that activity “constitutes a trade or business … the net earnings from self-employment … resulting from those activities constitute self-employment income and are subject to the self-employment tax.”

So is Bitcoin a Viable Currency?

Since IRS treats cryptocurrency as property and instructs taxpayers to determine its fair market value on the date of exchange, some have argued that it isn’t fungible. The taxed value of the bitcoin I receive today is not the same as the bitcoin I receive tomorrow. If a taxpayer’s business regularly accepts Bitcoin, these rules present an extra layer of tax reporting that simply doesn’t exist for those that accept more common means of payment.

Want to Learn More About IRS Cryptocurrency Rules?

For a comprehensive look at the federal tax implications of cryptocurrency, read Internal Revenue Service Notice 2014-21.