When Bitcoins are stolen by hackers, the IRS is silent.
One of the questions asked by U.S. taxpayers regarding virtual currency is how gains or losses are treated and thus taxed by the IRS. While the IRS did issue Notice 2014-21 to address 16 frequently asked questions, the Notice only touches upon some of the realities of Bitcoin transactions (e.g., sales or exchanges).[1] What happens if an entire Bitcoin exchange suddenly loses millions of dollars in Bitcoin and the Bitcoin’s value plummets as a result? On August 2, one of the largest Bitcoin exchanges in the world, Bitfinex, had approximately 120,000 Bitcoins, worth $65 million, stolen by unknown hackers.[2] This was the second-largest successful confirmed attack on a Bitcoin exchange.[3] [4] Bitfinex says that its customers will lose a whopping 36% of their funds shared between all users, whether or not their Bitcoins were taken, to account for the losses.[5] [6] Customers will be given digital “tokens” (labeled “BFX”) that record each customer’s discrete losses, which may be redeemed for payment by Bitfinex or possibly exchanged for shares of its parent company, iFinex.[7] Of note, the price of Bitcoin dropped 20%, as low as $480 down from $607 per Bitcoin.[8]
What does the IRS say about how U.S. taxpayers affected by this large-scale hack job should treat this loss? To answer this question, let’s look how the IRS treats virtual currency gains or losses, as expressed in Notice 2014-21.
According to the IRS, “[t]he character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.”[9] But, it’s unclear the IRS would treat this Bitfinex loss as either a sale or exchange of virtual currency.
Putting that aside, Notice 2014-21 states that virtual currency is not treated as currency that could generate foreign currency gain or loss for US federal tax purposes.[10] Also, the IRS does recognize gains or losses upon an exchange of virtual currency for other property, where the taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency. [11] The type of gain or loss a taxpayer realizes on the sale or exchange of virtual currency (a.k.a. the character of the gain or loss) depends on whether the virtual currency is a capital asset in the hands of the taxpayer.[12] However, neither situation is instructive here. When hackers simply “take” Bitcoin, there is no exchange for other property. Perhaps one could attempt to argue the “BFX token” received to record losses is some sort of property; however, we’ll need to know more about this “BFX token” before that question can be answered.
Unfortunately, IRS Notice 2014-21 is all the IRS has stated to date regarding gains and losses of virtual currency. Note that the agency has only spoken generally to gains or losses related to sales or exchanges. Thus, it remains uncertain how U.S. taxpayers should treat a loss caused by theft by hackers and a unilateral decision by a Bitcoin exchange to spread the losses among all users, which has nothing to do with any sale or exchange. Hopefully, this major breach will give the IRS a nudge to issue another much-needed notice with more in-depth guidance embracing the growing realities of Bitcoin.
—By Keobopha Keopong, Esq., Barnes Law
Keo Keopong is an associate attorney with Barnes Law, licensed to practice law in California.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Read more here: http://www.barneslawllp.com/virtually-no-tax-guidance-virtual-currency/
[2] http://www.businessinsider.com/hacked-bitcoin-exchange-bitfinex-all-customers-will-share-losses-lose-36-funds-2016-8?r=UK&IR=T; http://www.bbc.com/news/technology-37009319
[3] Ibid.
[4] “Back in 2014, MtGox, then the largest exchange, collapsed after $460 million in bitcoin was stolen by apparent hackers. Ethereum — an alternative digital currency — has recently been rocked by an attack on the DAO, a decentralised organisation that ran on its blockchain. The attacker managed to obtain $50 million-worth of Ether, but the community effectively split the currency in a "hard fork" to prevent them from being able to use it.” (http://www.businessinsider.com/hacked-bitcoin-exchange-bitfinex-all-customers-will-share-losses-lose-36-funds-2016-8?r=UK&IR=T)
[5] http://www.businessinsider.com/hacked-bitcoin-exchange-bitfinex-all-customers-will-share-losses-lose-36-funds-2016-8?r=UK&IR=T ; http://www.bbc.com/news/technology-37009319
[6] “After much thought, analysis, and consultation, we have arrived at the conclusion that losses must be generalized across all accounts and assets. This is the closest approximation to what would happen in a liquidation context,” stated Bitfinex in an August 6 blog post. (http://www.businessinsider.com/hacked-bitcoin-exchange-bitfinex-all-customers-will-share-losses-lose-36-funds-2016-8?r=UK&IR=T); “The ‘vast majority’ of people held bitcoins in exchanges and online wallets, according to security expert Prof Alan Woodward at the University of Surrey. ‘It's a bit like your bank account having money taken from it and then your bank writing to all customers saying it will spread the losses across all of them,’ he told the BBC.” (http://www.bbc.com/news/technology-37009319)
[7] http://www.businessinsider.com/hacked-bitcoin-exchange-bitfinex-all-customers-will-share-losses-lose-36-funds-2016-8?r=UK&IR=T; http://www.bbc.com/news/technology-37009319
[8] Ibid.
[9] IR-2014-36, March. 25, 2014 <https://www.irs.gov/uac/newsroom/irs-virtual-currency-guidance >.
[10] Notice 2014-21, Q-2, A-2 <https://www.irs.gov/pub/irs-drop/n-14-21.pdf>
[11] Notice 2014-21, Q-5, A-6 <https://www.irs.gov/pub/irs-drop/n-14-21.pdf>
[12] Notice 2014-21, Q-7, A-7 <https://www.irs.gov/pub/irs-drop/n-14-21.pdf>