As you may have now heard, on March 25, 2014, the IRS declared that, at least for now, Bitcoin will be taxed as property, rather than as a currency. For those who view bitcoin as an investment vehicle similar to stocks, this ruling sets a clearer path with well known “rules of the game” for dealing with the tax implications of bitcoin.
But for those who are interested in bitcoin as a new currency, the path is now cluttered with administrative, legal, and financial complexities.
In order to better understand the implications of the IRS’ new stance, let’s take a quick look at the taxation of property. Generally speaking, if you purchase property and it appreciates in value, you must pay tax on the gain you realize above the original purchase price when you sell the property. This rule has traditionally applied to stocks and bonds in the same way that is applied to real estate and other physical property. Now this tax treatment has been extended to apply to bitcoin as well. Where this starts getting interesting is that bitcoin, like stock, fluctuates in value. An upside to the determination that bitcoin will be taxed as property is that gains on property held for more than one year are subject to long term capital gains tax rates, which max out at 23.8%, as opposed to the higher tax rates which apply to short term capital gains or ordinary income. Conversely, if the value of bitcoin depreciates, the loss realized on the sale of such a depreciated bitcoin when it is sold can be written off against ordinary income, up to $3,000 in loss per year. These rules on the sale and disposition of assets are tried and true and readily accessible (see IRS Publication 544). In that sense, the IRS’s decision may be seen as a desire to keep things simple. But what are the implications on the use of bitcoin to pay for everyday purchases?
A popular example circulating the Internet right now discusses the implications of purchasing a cup of coffee with bitcoin. If the purchaser buys a $2 cup of coffee with a bitcoin that he purchased for $1, the purchaser actually realizes $1 in capital gains. In case this concept seems a bit confusing, let’s briefly look at the basic elements of gain. The Internal Revenue Code (“IRC”), section 61 defines “gross income” as “all income from whatever source derived.” The Supreme Court has held that “income” exists whenever you experience an “accession to wealth”. See Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431-33 (1955). In other words, whenever you are richer, even in some small way, you’ve realized gain. So in the coffee example above, in exchange for the dollar you invested in Bitcoin, you received one dollar worth of coffee, but you also received one additional dollar worth of coffee without paying anything additional. You are essentially one dollar richer than you were before, and so, you have taxable gain. Hmmm… a bit complex for buying coffee isn’t it? Actually, it’s even a little more complex still.
One of the great strengths of bitcoin is the highly developed means of tracking bitcoins. This built-in tracking system helps prevent counterfeit and similar fraud, prevents redundant use of the same bitcoin, and helps make bitcoin more reliable as a source of payment. However, because bitcoins can be tracked, and because their value fluctuates, a bitcoin you bought last year and a bitcoin you buy today can be tracked to determine when each is sold or exchanged for goods or services, and the tax implications for each bitcoin. The price you pay when you obtain any given bitcoin is referred to as your “basis” in that bitcoin, and the tax to which you are subject is based upon the gain you realize in excess of that basis in the bitcoin when the bitcoin is either sold or exchanged for a good or service. This means that which bitcoin you use to make a purchase matters.
Let’s go back to our coffee example. As stated, if you get $2 worth of coffee for $1 in bitcoin, you have realized $1 worth of gain. Your basis in the bitcoin was $1 and you exchanged it for value of $2, thereby realizing $1 in gain. If, however, you buy $2 worth of coffee with bitcoin you bought for $2, your basis in the bitcoin is $2 and you have no gain. If you buy $2 worth of coffee with $3 worth of bitcoin, then you have realized a loss! So, as stated, which bitcoin you use to make a purchase matters. Imagine, for example, that you have to track all of the bills in your wallet by serial number and have to keep records to determine differing amounts of gain or loss on a transaction based on when those bills came into your possession, when they were spent, and the value of the thing you received in exchange for the bills when you spent them. This is essentially what will be required of bitcoin when they are used to purchase goods or services. Of course bitcoins are digital, so tracking them is not quite like tracking the serial numbers of your dollar bills, but nonetheless, you can see how this certainly complicates bitcoin as a payment source, at least for now.
From a business perspective, the IRS determination has a number of interesting implications. Take for example bitcoin “mining.” If you aren’t familiar, “mining” is the way in which bitcoins are generated. Bitcoin miners are essentially service providers who process transactions and secure the bitcoin network by solving complex mathematical problems, in exchange for which they collect new bitcoins. The process is competitive, however, and does not always result in the award of a new bitcoin. If the work does result in the award of a new bitcoin, the value of that bitcoin on the day it was mined is taxable income. Consider wages. If bitcoins are rendered as wages in a business, they are subject to federal income tax withholding and payroll tax and must be reported on W-2s or 1099s. If a business accepts bitcoin as payment, it will be taxed on the fair market value of the bitcoin payment in US dollars on the date it was received as part of the business’s gross income.
For my two cents (or bitcoins?), the IRS’ determination appears to be a subtle, yet rather clever way of de-legitimizing bitcoin as a payment source by making it more complex to use in this way. I could be wrong, and maybe the IRS simply decided not to reinvent the wheel. In fairness, bitcoin does resemble a stock or publicly traded commodity in many ways, and there are tried and true guidelines for tax implications regarding the handling and taxation of those types of property. So maybe it’s a fair determination after all. “But currencies can fluctuate in value, too!” you say. Well, that’s true. So with approximately 9 million more bitcoins left to be mined until the Bitcoin supply reaches its predetermined maximum, there remains considerable room for controversy and potential changes of position by the IRS and other governmental entities. The one thing we know for certain at this point is that, for better or worse, at least for now bitcoin is taxable as property… and if you buy a $2 cup of coffee for a bitcoin you bought for $1, you may well find that you owe Uncle Sam capital gains tax on that extra dollar at the end of the year.