With tax day just weeks away, the IRS has issued a stern reminder that any income from virtual currency transactions must be reported on your tax return. The government views these types of transactions like any other exchange of property. Taxpayers who do not properly report digital currency transactions could face an audit and be held liable for penalties and interest.

What is Virtual Currency?

According to the IRS, virtual currency “is a digital representation of value that functions in the same manner as a country’s traditional currency.” Currently, there are more than 1,500 known virtual currencies, such as Bitcoin and Litecoin. The IRS recognizes that virtual currency is now used to pay for goods or services or held for investment purposes.

In some circles, these types of monetary units operate just like a traditional currency even though they do not have legal tender status in any jurisdiction. They are considered to be a “convertible” currency that has an equivalent value in legal tender.

For example, Bitcoin can be digitally traded and can be purchased for, or exchanged into, U.S. dollars, Euros and other real or virtual currencies.

Digital Currency is Considered Taxable Income

Recently, the IRS reiterated that the sale or exchange of virtual currency, or the use of it to pay for goods or services in a real-world transaction, has tax consequences that could result in a tax liability.

Taxpayers may be subject to penalties for not properly documenting these types of transactions. For example, you could receive an underpayment penalty for not assessing the fair market value of such transfers of goods or property.

In extreme situations, failure to properly report virtual these transactions could result in criminal tax evasion charges. The penalty for such crimes is as much as five years in prison and a fine of up to $250,000.

You Must Document Virtual Income

If you were paid in Bitcoin in the last year, this transaction must be included in your calculation of gross income. All transactions involving virtual currencies must be measured in U.S. dollars as of the date of the payment or receipt.

Digital currencies are treated as property for Federal income tax purposes. The same general tax principles that apply to property transactions apply to those involving virtual currencies.

For example, if you paid your employees’ wages in Bitcoin or another alternative currency, it must be documented on a Form W-2. You are also still responsible for Federal income tax withholding and payroll taxes.

Although the law has been on the books for several years, the increasing popularity of alternative currencies, like Bitcoin, has prompted the IRS to issue a stern reminder to taxpayers just ahead of the April 17 tax deadline.

If you have any questions about how to document digital currency transactions, contact a local tax professional.