What? I bought something with Bitcoin and now I have to report it on my tax return?

Yep. If you’re a US-based tax filer and you purchased something with bitcoin, then the IRS requires that you report this on your tax return – including the 2014 tax return that’s due here, soon, in April.

This is because the IRS classifies Bitcoin as “property” and not “currency”. This means that it is a capital asset, where you have to track the price you acquired it for and the price you sell it at. So when you are in fact buying something with bitcoin you are in effect selling it as well due to this specific capital asset classification.

What’s a capital asset? Examples of capital assets are real estate, factory equipment, and heavy machinery – ironically, assets that are thought to not be easily convertible to cash and are expected to be held longer than one year. Therefore, due to the fact that bitcoin is considered a capital asset, if you hold it for less than a year and it’s worth more than what you bought it for when you use it to purchase something, you have to pay a short term capital gains tax. This is the same tax rate that you would pay for your income tax bracket.

This starts to get a little tricky if you have several instances where you purchased bitcoin and need to figure out which purchase price you want to ascribe your bitcoin redemption to when you’re paying for lunch or dinner.

Why is it tricky? Well, first off, in most cases the purchase quantity of bitcoin is not identical to the redemption amount. In other words, let’s go back to the buying a dinner example – let’s say in January of 2014 you purchased $100 worth of bitcoin. In February you purchased another $25 of it. In July you sold the equivalent of $75. In August you bought another $10. In November you purchased $30 worth. And in December you paid for take-out with $30 worth of bitcoin. What is the purchase price you need to compare your dinner purchase with to correctly report this capital asset transaction on your tax return?

There’s actually a few different ways you can do it that are all compliant with IRS guidelines.

Method #1. The FIFO Method. In this method you would report your dinner purchased ascribed to the January 2014 example above, when you purchased $100 worth of bitcoin. Assuming you purchased $100 of bitcoin in January 2014 when the price was high and purchased your take-out in December 2014 when the value of bitcoin was much lower, you would owe no tax and you could write off the equivalent value of the loss to off-set your income comparative to the percentage decline of bitcoin between January 2014 and December 2014.

Method #2. The LIFO Method. In this method you report the dinner in relation to the November purchase of bitcoin in the above example. Let’s say hypothetically that between November 2014 and December 2014 when you purchased the dinner, the value of bitcoin had gone up. You would owe tax based on the percentage increase in the amount of bitcoin you used to pay for dinner compared to your purchase price in November.

Method 3. The Libra-Optimized Method. In this method, we analyze all of your bitcoin purchases in the example above and assign the bitcoin to the purchase-instance from 2014 that would generate the biggest lost, or if none, the smallest gain for you.

For any method, LibraTax will automatically import all of your transactions 2014 and calculate your gains and/or losses. In most cases, this takes just a few minutes. Afterward we’ll even automatically fill out the IRS Form 8949 that you need to include with your tax return.

Try LibraTax for free.