Bitcoin used to be something like Schrodinger\u2019s currency. Without regulatory observers, it could claim to be money and property at the same time.<\/p>\n
Now the Internal Revenue Service has opened the box, and the virtual currency\u2019s condition is established \u2013 at least for federal tax purposes.<\/p>\n
The IRS recently issued guidance on how it will treat bitcoin, and any other stateless electronic competitor. The short answer: as property, not currency. Bitcoin, along with other virtual currencies that can be exchanged for legal tender, will now be treated in most cases as a capital asset, and in a few situations as inventory. Bitcoin holders who are not dealers will be subject to capital gains tax on increases in value. Bitcoin \u201cminers,\u201d who unlock the currency\u2019s algorithms, will need to report their finds as income, just as other miners do when extracting more traditional resources.<\/p>\n
Though this decision is unlikely to cause much turbulence, it is worth noting. Now that the IRS has made a call, investors and bitcoin enthusiasts can move forward with a more accurate understanding of what they are (virtually) holding. A bitcoin holder who wants to comply with the tax law, rather than evade it, now knows how to do so.<\/p>\n
I think the IRS is correct in determining that bitcoin is not money. Bitcoin, and other virtual currencies like it, is too unstable in value for it to realistically be called a form of currency. In this era of floating exchange rates, it\u2019s true that the value of nearly all currencies changes from week to week or year to year relative to any particular benchmark, whether it\u2019s the dollar or a barrel of oil. But a key feature of money is to serve as a store of value. The worth of the money itself should not change drastically from day to day or hour to hour.<\/p>\n
Bitcoin utterly fails this test. Buying a bitcoin is a speculative investment. It is not a place to park your idle, spendable cash. Further, to my knowledge, no mainstream financial institution will pay interest on bitcoin deposits in the form of more bitcoins. Any return on a bitcoin holding comes solely from a change in the bitcoin\u2019s value.<\/p>\n
Whether the IRS\u2019 decision will help or hurt current bitcoin holders depends on why they wanted bitcoins in the first place. For those hoping to profit directly from bitcoin\u2019s fluctuations in value, this is good news, as the rules for capital gains and losses are relatively favorable to taxpayers. This characterization also upholds the way some high-profile bitcoin enthusiasts, including the Winklevoss twins, have reported their earnings in the absence of clear guidance. (While the new treatment of bitcoin is applicable to past years, penalty relief may be available to taxpayers who can demonstrate reasonable cause for their positions.)<\/p>\n
For those hoping to use bitcoin to pay their rent or buy coffee, the decision adds complexity, since spending bitcoin is treated as a taxable form of barter. Those who spend bitcoins, and those who accept them as payment, will both need to note the fair market value of the bitcoin on the date the transaction occurs. This will be used to calculate the spender\u2019s capital gains or losses and the receiver\u2019s basis for future gains or losses.<\/p>\n
While the triggering event \u2013 the transaction \u2013 is easy to identify, determining a particular bitcoin\u2019s basis, or its holding period in order to determine whether short-term or long-term capital gains tax rates apply, may prove challenging. For an investor, that might be an acceptable hassle. But when you are deciding whether to buy your latte with a bitcoin or just pull five dollars out of your wallet, the simplicity of the latter is likely to win the day. The IRS guidance simply makes clear what was already true: Bitcoin isn\u2019t a new form of cash. Its benefits and drawbacks are different.<\/p>\n