When you use cash to make a purchase in person, you hand over the dollar bills to the clerk. You give up the possession of the bill in exchange for the good or service you’re purchasing. You can no longer use this specific dollar bill for another purchase; it is in the possession of the business now. But you still have other dollar bills to use elsewhere.

With the advancement of technology came e-commerce. Online shopping is now a convenient way for consumers to purchase goods and services from the comfort of their own home or right off of their smartphone. Because of this, e-commerce relies on digital currency to make transactions. But unlike handing over a physical dollar bill, users had the opportunity to copy files containing digital currencies and use the same money multiple times.

Banks solved this problem by creating their own computerized ledgers to track transactions and balances of everyone’s accounts. However, many people have issues with a third-party central authority over their money. They wanted a secure and private way to control their money without an outside entity, thus sparking the development of cryptocurrency.

What is cryptocurrency? What is Bitcoin?

Cryptocurrency is a decentralized digital currency that is secured through encrypted codes to protect its users’ transactions and balances.

The most popular cryptocurrency is Bitcoin. It does not require a central authority to validate transactions between users. Instead, the transactions are verified through the massive network of Bitcoin users.

Before going further, one important distinction to make is the difference between “Bitcoin” and “bitcoin.” Bitcoin, with a capital B, is the name for the protocol and network as a whole, while bitcoin, with a lowercase B, is the name for the actual currency.

How Does Bitcoin Work?

Since Bitcoin is decentralized, every participant has a copy of the ledger, called blockchain, on his or her own computer. There is no sole person controlling it; no one can give him or herself more bitcoins because everyone’s ledger needs to match. The blockchain technology is transparent to all the users, so you can see all of the transactions and balances in place. While these actions are open and trackable, you can’t see who sends what to whom. User identities are kept anonymous.

You have a few options for how to get bitcoins. You’ll first have to create a Bitcoin wallet, after which you can find multiple ways to buy bitcoin. You can buy bitcoin using your bank account, purchase bitcoin from peer sellers, or withdraw from a Bitcoin ATM. Once you have bitcoin in your wallet, you can then find participating vendors and businesses to make a transaction.

Because it's all digital, one single bitcoin can be divided into very small fractions. So if your purchase is not worth an entire bitcoin, it can be cut in half or all the way down to 0.00000001 of its original whole.

You can choose to buy bitcoins, accept bitcoins as payment for a good or service, or earn bitcoins through a process called "mining," which is explained below.

How Bitcoin Mining Works

To maintain the blockchain, users can participate in what’s called “mining.” Bitcoin mining is the process of validating and updating the blockchain. This is done by using extremely powerful computers that race against one another to solve an equation by guessing a specific number.

The first “miner” to guess correctly gets to record the next batch of transactions to add to the blockchain. These newly written transaction confirmations are called “blocks.” Each block is sent to the other computers in the network to update the entire blockchain. On average, a new block is added every 10 minutes. In return, the original miner is rewarded with new bitcoins. The current reward per block is 12.5 bitcoins.

If you are interested in mining, you’ll need to upgrade to a highly powerful computer to be successful. Because these equations are extremely difficult, more advanced computers have been developed to make multiple guesses per second. Application specific integrated circuits (ASICs) are the current mining standard as they were manufactured solely for mining Bitcoin.

What is the Value of Bitcoin?

The value of bitcoin fluctuates every day. As of November 26, 2018, the value of 1 bitcoin is $3,632.30 U.S. dollars. In December 2017, 1 bitcoin was valued at almost $20,000 USD. But a few months later on March 31, 2018, the value of 1 bitcoin was $6,994.80 USD. So within the past twelve months, the exchange rate of bitcoin has dropped dramatically.

The Risks of Bitcoin

While the idea of a decentralized digital currency is appealing to some, there are a handful of risks associated with that.

• The volatile value of one bitcoin can be enough to consider if getting involved is even worth it.
• There is no formal protection for the individuals. Unlike your FDIC-insured bank account, nothing protects your wallet if the market goes south.
• It’s not a formally accepted form of currency everywhere. While some businesses accept bitcoins for payment, many others keep a leery eye on it and prefer to accept legal tender currency.

How to Report Bitcoin Income and Pay Taxes on Cryptocurrency

While it’s not a legal tender currency, the IRS recognizes that many consumers use Bitcoin and other cryptocurrencies as a form of payment. In response, it released guidelines that clearly define the cryptocurrency tax laws.

• When computing gross income, any taxpayer who accepts virtual currency as a form of payment for goods or services must include the fair market value of the virtual currency in USD as of the date that the virtual currency was received.
• Employers paying with Bitcoin must report employee earnings to the IRS on W-2 Forms. The bitcoin value must be converted to the USD value as of the date each payment is made. Wages paid in virtual currency are subject to withholding to the same extent as dollar wages.
• Employees paid in Bitcoin will need to convert their W-2 wages to USD and report as such.
• Any Bitcoin held as a capital asset will be taxed as property. General tax principles applicable to property transactions also apply to transactions that use virtual currency. Any gain or loss from the sale or exchange of the asset is then taxed as a capital gain or loss.
• Bitcoin miners must report any earnings as income. The bitcoins earned must be converted into the fair market value of the USD at the time of the earning.

In November 2018, Ohio became the first U.S. state, and one of the first governments in the entire world, to allow businesses to pay taxes using bitcoin. Businesses can register through OhioCrypto.com and pay any of the 23 different types of state taxes with bitcoin. The website will then, through a third-party processor called BitPay, convert the bitcoin into USD to then deposit into the state's accounts. The hope is to eventually extend this option to individuals for the same purposes.

Get Help with Cryptocurrency Accounting, Preparing and Reporting

If you use Bitcoin or any other cryptocurrency, you’ll want to make special preparations for your tax return. Today’s tax laws are already tricky enough, and throwing in the considerations for cryptocurrencies only adds to the confusion.

Most taxpayers, whether they use Bitcoin or not, benefited from using a professional tax preparer. Call Watson CPA today for a free consultation to learn how to best prepare your tax return.

Photo by Viktor Forgacs on Unsplash