What is virtual currency

Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. It operates similarly to "real" currency in some environments but does not have legal tender status in any jurisdiction. Virtual currency can be used to pay for goods or services or held for investment purposes.

There are two main types of virtual currency:

1. Convertible Virtual Currency (CVC): This type of virtual currency has an equivalent value in real currency or acts as a substitute for real currency. It can be exchanged back and forth for real currency. Bitcoin is a well-known example of convertible virtual currency. CVCs can be traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.
2. Non-convertible Virtual Currency: This type of virtual currency is intended to be specific to a virtual domain or world, such as a Massively Multiplayer Online Role-Playing Game (MMORPG) or a specific retailer. Non-convertible virtual currencies cannot be exchanged for fiat/real currency.

Virtual currency transactions are conducted through secure, dedicated networks on the internet, often using cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Units of virtual currency are generally referred to as coins or tokens.

For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. This means that when virtual currency is used to pay for goods or services, the fair market value of the virtual currency, measured in U.S. dollars as of the date of receipt, must be included in gross income. The basis of the virtual currency received is its fair market value in U.S. dollars as of the date of receipt.

Additionally, taxpayers may realize gain or loss upon the exchange of virtual currency for other property. The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. If the virtual currency is a capital asset, the gain or loss is typically capital in nature. If it is not a capital asset, the gain or loss is ordinary.

The IRS has issued guidance on the tax treatment of virtual currency transactions, including Notice 2014-21 and Rev. Rul. 2019-24, which provide detailed information on how existing tax principles apply to virtual currency.

Sources:
Notice 2014-21
Rev. Rul. 2019-24
Publication 544 (2023)
Issues in the Taxation of Cryptocurrency
IRM Part 4. Examining Process. Chapter 26. Bank Secrecy Act. Section 9. Examination Techniques For Bank Secrecy Act Industries
Notice 2023-34
Publication 5409 (6/2020)