When the Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) announced its rules for Bitcoin and other “cryptocurrencies” a little over a year ago, observers knew it was only a matter of time before the IRS would follow suit with its own guidance on how to treat virtual currencies for tax purposes. This past Tuesday the Service finally did so, releasing Notice 2014-21 which clarifies the Service’s position on how to properly report transactions involving Bitcoin and other virtual currencies, effectively killing any chance of Bitcoin’s widespread adoption as a substitute for official currency in the US.
FinCEN’s guidance document, released on 18 March, 2013, made clear that Bitcoin and other virtual currencies would not be treated as currencies at least as far as FinCEN’s regulations were concerned. Given this background, it was unsurprising when Tuesday’s IRS notice mirrored this treatment, stating that Bitcoin and other virtual currencies need to be treated as property, not currency, for federal tax purposes.
The upshot of this is that bitcoins, and other similar virtual currencies, are now officially subject to all the reporting requirements typically associated with barter transactions and the system’s anonymity in practical matters has been dealt a substantial blow given that businesses, historically unwilling to tangle with the IRS in most matters, are likely to acquiesce to the Service’s reporting requirements. To understand these reporting requirements, let’s look at a few typical scenarios:
Bitcoin “Miner” Successfully “Mines” Bitcoin: Here, the mined bitcoins (or, more likely, fractions of a bitcoin) are income to the miner on the day they are received. The miner is responsible for keeping track of his or her basis in each bitcoin (or fraction of a bitcoin) using, “a reasonable manner that is consistently applied.” While this seems to grant the miner a lot of leeway given that there is no single exchange rate for virtual currencies and the values on various exchanges can vary significantly even at the same point in time, as a practical matter I find it unlikely that the Service would accept a miner assigning basis based on whichever exchange provided the most advantageous tax value at the time of receipt. Given Bitcoin’s volatility, this could create a situation where a miner receives his or her bitcoins (or fractions of bitcoins) on a day when the value is peaking, creating an artificially large amount of income for tax purposes, with the loss being locked away in the bitcoins until they are spent or sold. Worse, the likelihood is that income from bitcoin mining is, in most circumstances, going to be classified as ordinary income, while the gain or loss from the sale or transfer of bitcoins will be capital gain or loss. This means that a bitcoin mined at peak value and then sold or transferred at a lower value will not be able to use the loss from the sale or transfer to offset the gain from the initial mining as capital losses cannot be used to offset ordinary income.
Bitcoin User Buys a Product or Service with Bitcoin: Here, the Bitcoin user will need to keep track of the gain or loss involved in the transaction. As Steven Rosenthal over at TaxVox put it:
Suppose I acquired a Bitcoin last month for $800, which appreciates in value to $900. If I use the Bitcoin to buy a $900 television, I would have $100 of gain, which is equal to the value of the TV less my $800 basis in the Bitcoin.
Naturally, this would also hold true if the values were reversed (i.e. if the user bought, or mined, a bitcoin for $900 and later used it to purchase a TV worth $800, the user has a capital loss of $100). Things get more complicated in reality since most bitcoins are mined or purchased as fractions of a bitcoin and the gain or loss would need to be individually calculated for each “piece” of the transaction if the exchange involved bitcoins, or pieces of bitcoins with different bases being aggregated.
Bitcoin User Purchases Bitcoin: This is the simplest case; the bitcoin user would simply take the bitcoin (or fraction of a bitcoin) with a basis equal to the purchase price of that bitcoin in US dollars. If they later use that bitcoin (or fraction of a bitcoin) to purchase something more or less than their basis in the bitcoin (or fraction of a bitcoin) they will then record a capital gain or loss, respectively.
By now, the die-hard Bitcoin fans are likely saying, “So what? The protocol’s anonymous and if I don’t report anything, the IRS will never know.” Well, leaving aside my former professor’s advice that, “any plan which includes the phrase, ‘they’ll never notice’ is a bad plan,” the simple fact is that the idea that enough businesses would forgo their reporting requirements for the Service to truly remain in the dark over significant transactions is inconceivable (and yes, this time the word does mean what I think it means). Sure, the Service cannot simply look at the block chain to find out who made the payment to the business, but think about the sorts of sales records that businesses keep. Amazon has your name and address and a list of everything they’ve ever shipped to you. Overstock.com, a company which made waves by accepting bitcoins as payment in January of this year, must have similar records. Do you really think that they don’t know which transactions (and therefore which names and addresses) used bitcoins?
There are, of course, ways to overcome the reporting issues (indeed, some users are already working on services that will automatically track basis). And there’s no way to catch everyone, so there will always be a few people out there who accept the risk inherent with a strategy that says, “they probably won’t audit me.” But there’s no escaping the fact that this notice makes the everyday reporting requirements for using bitcoin and other virtual currencies ,ore demanding and less convenient than those for using traditional, “real” currency. Though I don’t believe that Bitcoin is going to disappear entirely, I do ultimately agree with Adam Levitin over at Credit Slips when he says that he just doesn’t see Bitcoin ever becoming a true medium of exchange under these conditions. Bitcoin will no doubt hang around as a speculative medium and as the darling of sovereign citizen types, but the IRS seems to have very effectively destroyed the possibility of Bitcoin ever being a true replacement for the good old US greenback.