Bitcoin and the unnecessary ambiguity around taxation

By Michael Carney , written on December 26, 2013

From The News Desk

Now that the eggnog is all drunk and the presents opened, New Years Eve is just a stones throw away. It’s been an eventful year, but if you participated in the bitcoin ecosystem to any meaningful level, your year has likely been wilder than most. As we put 2013 in the books, there’s another, slightly less beloved “holiday” creeping up on us: tax day. For bitcoin aficionados it’s bound to be a particularly nerve wracking and potentially maddening time of year.

For all the “discussions” and “evaluation” taking place at a federal level regarding virtual currencies, there has been a decided lack of definitive guidance or new regulation passed regarding their legality, classification, or tax treatment. That means that if nothing changes between now and April 15, bitcoin miners, merchants, traders, and consumers, along with their tax professionals, all will be flying blind when filing their taxes.

There seems to be a general consensus, both among tax professionals and simple bitcoin enthusiasts, that virtual currencies are legally subject to taxes, even though many wish this weren’t the case and opine on ways to hide bitcoin activity from the IRS. But, even for those looking to abide by the law, questions abound about how to classify bitcoins, be it as a currency, a commodity, or as an asset, each of which has profoundly different tax consequences. A simple Google search for “bitcoin taxes” returns several thousand, mostly conflicting links in this regard. There is an argument to be made in favor of each classification, but without official guidance from the federal government, drawing any conclusions would be purely speculative.

Bitcoin began the year trading in the range of $12 and reached an all-time-high of more than $1,240 in early December before falling to $422 and rebounding to today’s value of $775. Countless times over the past 12 months, the crypto-currency gained and lost tens or hundreds of percentage points in value within the span of days. Depending when (and how) people acquired their bitcoin, and where along the way they sold, there are a number of different plausible tax scenarios.

If it is determined that bitcoins are a currency then any earnings made in trading them will be taxed as ordinary income. This would mean bitcoin would be taxable at a rate of 39.6 percent in the highest income bracket. The only way this could change would be if a futures contracts market emerges, similar to the one that exists currently for other foreign exchange currencies (FX), meaning traders can avoid taking ownership of actual bitcoin.

One argument against bitcoin receiving currency tax treatment comes from the Supreme Court case California Bankers Assn. vs Shultz in which the court ruled that “Currency” is defined as the coin and currency (aka, paper) circulated by the US or any other country and which is used and accepted as money in the issuing country. Because bitcoin is not issued by any country and is not widely accepted as money, it would seem to fail this classification test, at least superficially.

By comparison, if bitcoin is officially classified as an asset, then its use will be subject to capital gains and losses taxes. These rates cap out at just 20 percent, but come with a major caveat. To receive long-term capital gains treatment, one must hold an asset for a minimum of one year. Anyone who bought bitcoin in 2013 and sold it within the calendar year is likely subject to ordinary income tax on the gains or losses, regardless of how the government ultimately classifies things. Things get even hairier if you hope to treat bitcoin as a business, although that’s a discussion for another time and place.

Canada, Sweden, and Norway have all concluded that bitcoins will be treated as an asset for tax purposes. Germany, on the other hand, has classified it as a “financial instrument” but not not “e-money” or a foreign currency. Tax rules in these countries vary slightly from the US, but these decisions set a precedent that would suggest bitcoin may ultimately be taxed as an asset in the US. Notably, the Winklevoss brothers noted in a public filing for their Winklevoss Bitcoin Trust that the fund plans to treat bitcoin as a capital asset instead of a currency, pending any contradictory guidance from the IRS.

For anyone who has made big profits in bitcoin, and who meets the one year holding period requirement, classifying bitcoin as an asset, rather than a currency, would be preferable from a tax savings perspective. But, for anyone with major losses, ordinary income tax treatment would be preferable. This is because US federal tax law only allows individuals to deduct $3,000 worth of capital losses annually against ordinary income.

This means that if you made $100,000 in W-2 salary, and lost $100,000 in bitcoin (with no other capital gains), you could only deduct $3,000 worth of that loss each year against your income taxes, and would still be liable for paying income tax on the the remaining $97,000. All things being equal, this person could then take another $3,000 deduction each year for the next 32 years. No thank you. As complicated and maddening as this may seem, this is a relatively simple scenario.

Even if the above classification questions get sorted out, there are other ambiguities that will remain. For example, bitcoin and its altcoin cousins are traded on dozens of different exchanges around the world, with exchange rates often varying widely between them. The question then becomes, what is the official exchange rate one should use for establishing a "cost basis," or the starting price used for measuring taxable gains or losses?

Given all the uncertainty, and the general disdain that the average person holds for the IRS, it’s no wonder that many people question whether they have to even report and pay taxes on their bitcoin activity. At the present time, there are no banks, exchanges, or other third party institutions that report individual trading activity to the IRS. But it’s unlikely that this virtual wild west will last forever. And when reporting does begin, it’s reasonable to assume that the IRS will evaluate all past activity and look to recoup any unpaid taxes. Anyone who failed to report taxable income or gains could be subject to penalties, interest, or even civil and criminal prosecution.

Bitcoin has long been favored for its perceived anonymity. But this is a bit of a fallacy. Every bitcoin transaction is recorded in a global general ledger called the blockchain. This blockchain is then copied and verified by thousands of “miners” for its accuracy and completeness. Today, transactions are simply tied to individual bitcoin wallet accounts – which are little more than a long string of numbers – rather than to the trader’s name. But we live in an era of big data analytics, machine learning, and ever-increasing computational horsepower.

Even if it is impossible to uncover a trader’s identity today, it’s likely this will change one day in the not-too-distant future. Further, while anonymity may be possible within the bitcoin ecosystem, the second you convert out of bitcoin to a government issued currency, it becomes infinitely harder to hide that activity from the IRS.

The bitcoin tax situation is a mess and uncertainty is the order of the day. But that doesn’t mean ignoring taxation altogether is a viable option. If there has been one constant throughout history it’s that the government will always try to get its cut.

With Uncle Sam’s bank account deep into overdraft, bitcoin taxation is just too tantalizing a proposition to pass up.

[Image via Images of Money, Flickr]