How Should Bitcoin Be Taxed? IRS Provides Short Answer

April 10, 2014

With “Tax Day” looming for many Americans, it seems the perfect time to talk about the Internal Revenue Service (“IRS”). Bitcoin is a relatively novel form of currency that was first introduced in 2009. Unlike traditional currencies, Bitcoin operates “without central authority” and utilizes “peer-to-peer technology” and functions as a open source of payment around the world. Bitcoin functions like a stock, so its value varies considerably day-to-day as it is traded on a market, which is currently worth around $8 billion. Consequently, the use of Bitcoin raises a number of legal and policy questions. In recent years and months, one hefty question has lingered in the United States: how should the IRS treat Bitcoin for tax purposes?
In late March, the IRS offered a relatively short and sweet answer to that complicated question in the form of regulatory guidance. In its guidance, the IRS first classified Bitcoin as a “convertible virtual currency.” The agency then said that will treat Bitcoin as property for taxation purposes, as opposed to treating it as a traditional form of currency.
The tax issues built into Bitcoin are abundant, and this guidance is a starting point for addressing them. Bitcoin is used for normal transactions daily, but the currency can also be held for investment. The regulatory guidance released by the IRS in late March establishes that for tax purposes, Bitcoin will be treated as property. This means that Bitcoin held and sold for investment purposes will be treated as capital gains and taxed at the current capital gains rate. Bitcoin used in the everyday buying and selling of goods
Beyond that, if Bitcoin is used to pay wages, federal payroll taxes will apply to those as well. If nothing else, this new IRS guidance may boost tax revenue for the U.S. government, as previously untaxed transactions are now subject to clear taxation. Furthermore, there are severe tax implications for individuals who create new bitcoins by “cracking” computer code, also called “miners.” They will have to report the fair market value of the bitcoins as gross income, which will be subject to tax.
While the IRS regulatory guidance is certainly useful, it remains to be seen if it will prove itself as practical, especially from the enforcement side. Bitcoin prides itself on its “extensive privacy measures,” which some feel may present a challenge in tracking Bitcoin financial transactions and earned income that is paid via Bitcoin. From a capital gains angle, Bitcoin does leave an investment record, which will be reported to the IRS, much like other commodity sales. Compliance and avoidance issues are two other major hurdles for the IRS.
Virtual currencies, such as Bitcoin, present many issues and challenges from a legal front. The federal government is continuing to investigate and set guidelines for their use as they continue to make waves in the financial market and daily lives of Americans. A Texas Congressman introduced legislation this week to formally recognize Bitcoin as currency, as the idea and implications of virtual currencies is certainly a hot topic. While the recent guidance by the IRS is a solid start, many questions remain unanswered.