On March 25, 2014 the IRS issued Notice 2014-21, which describes how the IRS will interpret existing general tax principles to apply to transactions using “virtual currencies” such as Bitcoin. This Notice is the most recent in a line of similar regulatory pronouncements issued by several governmental actors such as the Government Accountability Office’s report in May of last year and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) Guidance memorandum issued March 18, 2013.

The most significant clarification contained in the Notice is that the IRS considers Bitcoin and other virtual currencies to be classified as property for the purposes of US tax law. This answers what had been a pressing concern to the crypto-currency community, namely whether virtual currencies would be treated for tax purposes as property or currencies in their own right.

While issued partly in response to the call for IRS guidance in the GAO report, the Notice eschews the GAO report’s taxonomy of “open-flow” versus “closed-flow” virtual currencies and largely adopts the definitions used by the FinCEN Guidance memorandum. The IRS defines a virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” While the IRS recognizes that “[i]n some environments, it operates like “real” currency—i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance…” the fact that virtual currencies do not “have legal tender status in any jurisdiction” distinguishes them from real currencies, both foreign and domestic. The IRS further elaborates that when the virtual currency has an equivalent value in real currency, or acts as a substitute for real currency, the IRS will refer to that as a “convertible virtual currency.” The IRS specifically names Bitcoin as one example of such a convertible virtual currency.

The lack of jurisdictional recognition means that convertible virtual currencies are excluded from the treatment of real currencies, and will thus be considered as property. Accordingly, they are subject to general tax principles applicable to property transactions instead of the “ordinary income” treatment that foreign currencies receive.

Briefly, with virtual currencies treated as property, investors holding virtual currencies for more than one year will likely be subject only to capital gains taxes rather than ordinary income tax. However, taxpayers who receive payment for good or services in virtual currencies will have to include in their computation of taxable income the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. This requirement may present challenges for individuals to use virtual currency for ordinary course personal transactions.

Similarly, virtual currency paid by employers as remuneration for services will be treated as wages for employment tax purposes, and generally subject to federal income tax withholding based on the fair market value of the virtual currency paid. In addition, virtual currency miners will have to recognize taxable ordinary income upon receipt of the virtual currency generated through the mining process. Individual miners will be subject to self-employment taxes on this income.

While the Notice provides simple hypothetical examples of various virtual currency transactions, it is important to consult tax counsel on any real-world transaction involving virtual currencies, as the complicated nature of tax law may have implications even beyond any virtual currency issues.