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Over the past few years, we have received a growing number of inquiries regarding the taxation of so-called virtual or cryptocurrencies from individuals who have purchased such currency and others who are mining the currency. Thus far, these issues have been analyzed under existing tax rules, with some guidance from the Internal Revenue Service (IRS). Recently, there has been a flurry of discussion regarding the IRS's increased focus on the taxation of cryptocurrencies. Further, IRS representatives have indicated that the topic is front-of-mind. This article outlines some of the primary tax issues and reporting obligations posed by such cryptocurrencies.

What Is Cryptocurrency?

In 2014, the IRS first addressed the issue of virtual currency in a 2014 notice to taxpayers. In that notice, the IRS described virtual currency as "a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value." Notice 2014-21. At their core, virtual currencies are just the newest version of currency. Historically, precious metals were used as currency to purchase goods or services. However, they were difficult to carry and store. Most modern currency, on the other hand, is known as "fiat currency." Fiat currency is generally issued by a government, which sets its value. The actual value of such currency can vary depending on the strength of the government and economy backing the currency.

Cryptocurrencies, a form of virtual currency, do not rely on the strength of a government or the amount of gold one can transport. Cryptocurrencies are by their nature decentralized and not tied to a particular country or a particular bank. Their value rests on such factors as the scarcity of the currency, the security of the currency and the ability to use it. Understanding exactly how such cryptocurrencies are produced and developed is complex, but the following is a summary of how cryptocurrencies work.

Bitcoin, still the most well-known cryptocurrency, is a network that uses cryptography and runs on a computer protocol known as blockchain. Blockchain is a system that acts as a public ledger to keep track of transactions that occur and permits users to verify transactions with each other. "Mining" or production of new units, which are referred to as "bitcoins," is limited by requiring computers to devote significant time and power to validate transactions, contribute to the public ledger and obtain the release of new bitcoins. This allows those who participate in bitcoin to have a level of confidence that the technology is secure (not easily counterfeited), that there is a known quantity of bitcoins available and that new bitcoins will not be flooding the market. There is an easily accessed market to purchase bitcoins, sell them and track prices. These bitcoins, as well as other cryptocurrencies, can be held in a user's wallet. This wallet is virtual in nature, similar to an account and consists of an encrypted numerical address.

Is Cryptocurrency Considered Currency?

One of the valuable aspects of these cryptocurrencies is that they can not only be used like money to buy goods, but can also be held for investment like a stock. Despite their name, cryptocurrencies are treated as property, not currency, by the IRS. If one is a vendor who accepts virtual currency for a transaction, this means that the vendor must track the value of the virtual currency, measured in U.S. dollars on that date it is received. Cryptocurrencies such as bitcoin (and some others) are convertible into U.S. dollars and listed on an exchange or exchanges that update a cryptocurrency unit's fair market value on a regular basis. If a virtual currency is not listed on an exchange, valuation can be difficult.