The Internal Revenue Service’s decision to treat Bitcoin as property will make tax consequences part of every transaction involving the virtual currency.
So much so that Bitcoin users and analysts say the IRS guidance announced yesterday complicates people’s ability to use it as a currency.
“This greater clarity creates greater wrinkles,” said Mark Williams, who teaches finance at Boston University. “This reinforces that strategy of holding it as a commodity, which then undermines its value as a transactional currency.”
The IRS, faced with a choice of treating Bitcoins like foreign currency or property, chose property. Exchanging Bitcoins for goods, services or dollars will generate taxable income or losses, depending on what the Bitcoin investor paid.
The IRS ruling could reduce the volume of transactions conducted with the virtual currency, said Pamir Gelenbe, a venture partner at Hummingbird Ventures. The firm invests in technology businesses.
Purchasing a $2 cup of coffee with Bitcoins bought for $1 would trigger $1 in capital gains for the coffee drinker and $2 of gross income for the coffee shop.
“It’s challenging if you have to think about capital gains before you buy a cup of coffee,” Gelenbe said.
Jered Kenna, a San Francisco-based entrepreneur who owns Bitcoins, said in an interview that after hearing about the IRS guidance he needs to “talk to my accountant.”
More seriously, Kenna said the new rules would complicate the smooth functioning of the Bitcoin payment network.
“You’re increasing the cost of accounting to everyone who touches a Bitcoin transaction,” Kenne said.
Others involved in Bitcoin downplayed the effects of the decision, saying it provides needed certainty for investors. Also, because Bitcoins are a long-term investment, much like stocks, the IRS ruling didn’t surprise them.
The ruling takes effect immediately and covers past and future transactions and tax returns. The IRS said in its notice that it may offer relief from penalties to people who engaged in transactions before yesterday and can show “reasonable cause” for underpayments or failure to file.
Bitcoin, the most popular digital currency, emerged from a 2008 paper written by a programmer or group of programmers under the name Satoshi Nakamoto.
The Bitcoin network uses a public ledger to record transactions made under pseudonyms, a technological breakthrough that allows purchases and sales without using a trusted third party, such as Visa Inc. or Western Union (WU:US) Co.
Powerful computers that record the transactions and guard against double-spending the same currency generate new Bitcoins, a process referred to as mining. Mining has made some early Bitcoin adopters wealthy in dollar terms.
Others bought into the currency in early 2013, before its price rose more than 50-fold to peak at $1,200 in early December. Bitcoin was priced at $581.86 at 8:05 p.m. New York time yesterday, according to the Coindesk Bitcoin Price Index.
In March 2013 the Financial Crimes Enforcement Network, like the IRS a part of the Treasury Department, acknowledged digital currencies like Bitcoin are fundamentally different than dollars. It said companies exchanging Bitcoins for dollars can be regulated as money transmitters.
That triggered a race among states, notably New York and California, to ascertain how or if their laws apply, since states typically license money transmitters. The Bitcoin industry has been frustrated that parts of the U.S. government are regulating the virtual currency in different ways.
“You see guidance from on high with no public input, which is unfortunate,” said Patrick Murck, general counsel for the Bitcoin Foundation.
The IRS ruling means Bitcoin investors will be treated like stock investors. They must determine their basis, or cost paid, for the Bitcoins, so they can tell whether a particular transaction results in a gain or a loss.
Someone who bought a Bitcoin for $400 and sold it for $500 would have $100 in capital gains.
Bitcoins held for more than a year and then sold would face the lower tax rates applicable to long-term capital gains -- a maximum of 23.8 percent. That compares with a 43.4 percent top rate on property sold within a year of purchase and the 39.6 percent top rate that applies to other types of income.
For investors with losses, U.S. tax law allows taxpayers to subtract capital losses from any capital gains.
Beyond that, they also can subtract as much as $3,000 of capital losses a year from ordinary income.
If Bitcoin were treated as a foreign currency, ordinary -- not capital gains -- tax rates would apply. Losses would be easier to deduct against ordinary income, however.
As with stocks, Bitcoin dealers will be subject to different rules that won’t allow for capital gains treatment.
Bitcoin miners will have to report their earnings as taxable income with a value equal to the worth on the day it was mined. They would use that as their cost basis and then pay gains or record losses when they sell or exchange the Bitcoins.
If they mine as part of a business, they’d have to pay payroll taxes as well.
The IRS will require information reporting similar to how the tax agency receives notification of stock transactions and payments to independent contractors.
It comes less than three months after National Taxpayer Advocate Nina Olson called on the IRS to issue taxpayer guidance on digital currency transactions.
“It is the government’s responsibility to inform the public about the rules they are required to follow,” Olson, who runs an independent office within IRS, wrote in her annual report to Congress in January. “The lack of clear answers to basic questions such as when and how taxpayers should report gains and losses on digital currency transactions probably encourages tax avoidance.”
Charles Allen, chief executive officer of BitcoinShop Inc., an online marketplace, said he’d like to see the IRS reconsider its decision as virtual currencies develop.
“The implications this decision will have on the Bitcoin ecosystem are far reaching, and will be burdensome for both individual users of Bitcoins, Bitcoin-focused business and for the general adoption of virtual currencies,” he said, adding that Bitcoin users will adapt to the rules.
To contact the reporters on this story: Richard Rubin in Washington at email@example.com; Carter Dougherty in Washington at firstname.lastname@example.org
To contact the editors responsible for this story: Jodi Schneider at email@example.com Don Frederick