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What the IRS’s Taxation Ruling Means for Bitcoin and Other Digital Currencies

The recent notice is a surreal step that brings what was once an anarchist’s dream come true closer to being a tool of the state.
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IRS Building in Washington, D.C. (Photo: Joshua Doubek/Wikimedia Commons)

IRS Building in Washington, D.C. (Photo: Joshua Doubek/Wikimedia Commons)

Where does the value of money come from? Is it from the bill or coin in your wallet, attached to a physical object? Or is money valuable mostly because of its transactionary nature, its ability to be swapped with like-minded people for other, more immediately usable goods?

The United States Internal Revenue Service recently ruled (PDF) that the value of digital currencies like Bitcoin comes more from the former option than the latter. Over the past few years, as Bitcoin’s value, along with those of other alternative currencies like Litecoin and Dogecoin, has multiplied exponentially, the biggest unanswered question was how the government would choose to deal with them. They weren’t outlawed outright, as some may have expected, but those Bitcoin holders hoping to get rich overnight with non-governmental money might be disappointed—they still have to pay their taxes.

An IRS notice released March 25 makes clear that transactions using virtual currencies count as “property transactions” under current tax law. “Virtual currency operates like ‘real’ currency,” it reads. “But it does not have legal tender status in any jurisdiction.” Rather than a legitimate foreign currency like the Chinese Renminbi, Bitcoin is actually a commodity with its own fluctuating value, like a stock or bond. That designation makes things a lot more complicated when it comes to tax time (less than a week away, for those counting).

All digital currency users now essentially work for themselves, running small businesses that just happen to function in a brand-new kind of money. Bitcoin is a cottage industry.

Digital currency miners—the people using their computers to solve complex math problems in order to release new money into the economy—have to track the value of their coins when first mined as well as when they use or sell them. If a miner mined one Bitcoin on January 1, 2013, when it was worth $13, then they must report $13 in direct income. Then, if they sold the Bitcoin on December 31, 2013, when it was worth roughly $1,000, they would be subject to capital gains tax on the $987 difference.

The IRS’s designation means that, at least when it comes to taxes, Bitcoin doesn’t really function as a currency at all. Even transactions carried out purely in Bitcoin without switching into U.S. dollars at any point are taxable as capital gains. So if our hypothetical miner spent $500 worth of Bitcoin to buy a couch, he is still liable for that full $987 in capital gains, since the value has accrued regardless—it just ended up in the form of a couch rather than digital currency.

In some ways, this is a good thing for digital currency holders. It means that gains in Bitcoin value aren’t taxed at a higher level as direct income. Capital-gains tax rates are lower than income tax, hence the appeal of getting paid in stock rather than salary. Ordinary income tax rates and tax on capital gains from the sale of assets held less than a year can go as high as 35 percent, but long-term capital gains tax rates for assets held longer are just 15 percent. For less wealthy investors, short-term rates can be as low as 15 percent (with long-term rates falling to 10 percent). The longer you hold your Bitcoin, the less tax you’ll pay on them.

Capital losses can also be reported on tax filings. So if you bought Bitcoin at its height of $1,000 and sold it after it decreased in value, that loss is deductible. Up to $3,000 in losses can be taken off other forms of income. (Those losses might be more relevant during this year’s tax due date in 2015; Bitcoin’s value has now fallen to around $450.)

THE FACT THAT THE IRS has decided how it wants to regulate digital currencies should come as something of a relief to users who feared they might be decimated entirely. But the sudden profusion of rules also dashes the hopes that Bitcoin would become the world’s first totally decentralized, untaxed, anonymous currency. It’s now less anonymous and more structured than ever before.

In order to properly report taxes, miners must now closely track when they successfully mine coins to determine their original value. Those buying Bitcoins must note the price they bought in at, creating a de-facto timeline of participation in digital currency markets. Getting paid over $600 in Bitcoin for a service is just like getting a job that pays U.S. dollars—employees must fill out W-9s and use their social security numbers. But the value of their salary also fluctuates, and then they’re subject to capital gains taxes if they cash out of Bitcoin at a later date.

On Reddit, one tax attorney also points out that digital currency exchanges could act as a warning system for those trying to dodge their taxes. With wire transfers of over $5,000, especially across international borders, banks are required to file suspicious activity reports, which could trigger investigation by the IRS. So there’s little chance of getting large amounts of money out of the Bitcoin system and into a U.S. bank account without at least one authority being alerted.

It’s a surreal step that brings what was once an anarchist’s dream come true closer to being a tool of the state. All digital currency users now essentially work for themselves, running small businesses that just happen to function in a brand-new kind of money. Bitcoin is a cottage industry.

Yet as Alex Hern points out in The Guardian, the taxes are still going to be difficult to enforce. While individual Bitcoins are identifiable by their numerical addresses, they run together like a herd of zebras. Within one user’s digital-currency wallet, there might be fractions of thousands of different Bitcoins, all bought and sold at different prices. So how do we determine which ones are transacted at which prices?

Hern suggests that an average price could be used, but also warns that Bitcoin “tumblers” that mix together many different Bitcoins into a single wallet before passing them on could complicate things further. At this juncture, it’s up to users to self-report and risk investigation if they don’t.

As Bitcoin prices increased dramatically over 2013, what most wallet-holders will be reporting are capital gains, not losses, and the federal government will benefit from an inrush of tax money from a market it did nothing to create or encourage—a net gain that should elicit few complaints, even if not every Bitcoin user reports their earnings.

Many questions remain. What happens when deductible capital losses in digital currencies start functioning as a form of money laundering? Will the IRS pursue Bitcoin millionaires—and there are many—who try to move their wealth into the real world without proper reporting? Will users selling off Bitcoins to pay for taxes dampen the digital currency market further?

One thing is clear: Though the tax structure forces it into more of a commodity than currency role, Bitcoin is sticking around.