Cryptocurrency is a form of digital money that is designed to be secure and, in many cases, anonymous. Bitcoin has become leader in shepherding in a wave of cryptocurrencies built on decentralized peer-to-peer network, it’s become the primary standard for cryptocurrencies.
Even though Bitcoin is labeled as a “cryptocurrency”, from a federal income tax standpoint, Bitcoins and other cryptocurrency are not considered a “currency.” On March 25, 2014, the IRS issued Notice 2014-21, which for the first time set forth the IRS position on the taxation of virtual currencies, such as Bitcoins. According to the IRS Notice, “Virtual currency is treated as property for U.S. federal tax purposes.” The Notice further stated “General tax principles that apply to property transactions apply to transactions using virtual currency.”
In other words, the IRS is treating the income or gains from the sale of a virtual currency, such as Bitcoins, as a capital asset, subject to either short-term (ordinary income tax rates) or long- term capital gains tax rates, if the asset is held greater than twelve months (15% or 20% tax rates based on income).
The Internal Revenue Code does not describe what a Self-Directed IRA or Solo 401(k) Plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. Because the IRS treats cryptocurrencies, such as Bitcoins, as a capital asset, such as stocks of real estate, a retirement account is permitted to buy, sell, or hold cryptocurrencies in their retirement subject to the prohibited transaction rules found under Internal Revenue Code Section 4975(c).
The IRS tax treatment of virtual currency has created a favorable tax environment for retirement account investors. In general, when an IRA generates income or gains from the purchase and sale of a capital asset, such as stocks, mutual funds, real estate, etc., irrespective of whether the gain was short-term (held less than twelve months) or long-term (held greater than twelve months), the IRA does not pay any tax on the transaction and any tax would be deferred to the future when the retirement account holder taxes a distribution (in the case of a Roth IRA or Roth 401(k) plan no tax would be due if the distribution is qualified).
Hence, using a self-directed bitcoin IRA to invest in cryptocurrencies, such as Bitcoin, could allow the investor to defer or even eliminate, in the case of a Roth, any tax due from the investment. That is why a smart tax attorney will use a self-directed Roth IRA to buy bitcoin and shelter all gains from tax.