Written by Johannes Schmidt, Alexander Derrick, Joseph Henchman
Since Bitcoin’s introduction in 2009, the IRS has left users in the dark about the tax liability of their assets. On Tuesday, the IRS clarified its position on the tax status of virtual currencies, and it’s official: Bitcoin is property and not currency, at least as far as the U.S. government is concerned. Any net gain from holding or transacting in Bitcoin is subject to capital gains taxes.
Bitcoin sold or used within a year of purchase are short-term gains and subject to ordinary income tax rates, which could be as much as 39.6%, whereas assets sold after a year of purchase are long-term and are taxed at lower rates. If you mine your own Bitcoin, this constitutes taxable gross income equivalent to their fair market value at that date.
While the IRS has finally provided an answer, there are good reasons to believe that they got it wrong. Virtual currencies are tricky assets to categorize. Sometimes they behave like currencies, sometimes like commodities, and sometimes like stocks. This unique quality is reflected by several wrinkles in the IRS’s approach to virtual currencies, treating them like both capital gains as well as wages.
The nature and volume of these transactions do not seem to marry well with the sorts of long-term capital investments which usually taxed at the lower rate. In fact, at Bitcoin’s most recent peak in November 2013, there were 93,000 transactions in a single day where people bought everything from haircuts to hoagies and houses. This suggests that Bitcoin is not used as a tool for long term investment.
The new policy also poses compliance obstacles. Users must maintain detailed records of their acquisitions and transactions made with the virtual currency, and the fair market value in U.S. dollars on each occasion. This may prove a daunting task, particularly given Bitcoin’s recent price volatility. While users with sizeable Bitcoin wallets might be motivated to comply with the new policy, those with smaller wallets might not find the hassle worth their time.
Additionally, the IRS policy (Notice 2014-21) is effective not only from March 25, 2014 onward, but retroactively as well. The IRS FAQ includes a question of whether penalties will be applied for people who don’t have records before the date of the notice; the FAQ answer dodges the question, simply asserting that “penalty relief may be available to taxpayers…who are able to establish…reasonable cause.” Applying penalties for disobeying a then-non-existent policy is wrong; being unclear about whether penalties will apply retroactively is worse.
All told, the IRS sees Bitcoin as something that people buy and hold, hoping it will go up in value. They completely miss the primary use of Bitcoin, as a currency for both transactions and wages. The tax treatment and compliance requirements as part of this notice are inappropriate for that usage of virtual currencies.