This is the third part of a multi-part series that will discuss how to declare Bitcoin income on US personal or business income tax returns. What follows are my professional opinions and should not be construed as tax or accounting advice. Instead, the articles in this series should be used as the starting point for a discussion with your tax accountant about your personal situation.
The IRS must answer two questions with regard to virtual currencies: what is their classification and when are gains or losses realized for the purpose of taxation? The first question has bearing on the rate that would apply in situations when Bitcoins are not received in connection with a trade or business or as wages. The second question relates to when gains must be declared or losses can be claimed.
The essence of Bitcoin is its use as a medium of exchange. Bitcoin behaves like currency, is used by both merchants and consumers as a currency and is denominated and can be subdivided like a currency. Its value is almost always stated with reference to currency. At least one agency of the Treasury Department, the Financial Crimes Enforcement Network, has publicly stated its belief that Bitcoin exchanges fall into the category of money servicers (that is, businesses that exchange or transfer currency) and its intent to regulate them as such. Therefore, the case for Bitcoin as something other than currency is fairly weak, but that does not rule out the possibility that the final regulations will turn out that way or that regulators will develop some sort of hybrid category for virtual currencies that combines various aspects of multiple asset classes.
The second part of this series discussed situations in which Bitcoin transactions would definitely be considered ordinary income and also possible tax treatment for Bitcoin as a currency. For almost all US taxpayers, the functional currency for tax reporting is the US Dollar (the exception would be business taxpayers with a qualified business unit, or QBU). Usually, “foreign currency” means the recognized legal tender of a nation-state or central bank. Since Bitcoin clearly does not fall into this category, the Treasury may ultimately decide that it should be treated as some kind of asset other than currency. Several countries besides the United States, notably several EU member states, have already determined that Bitcoin is a non-currency asset, though differences in tax treatment between Europe and the United States are not uncommon.
The IRS defines two types of assets for income tax purposes – capital assets and non-capital assets. All property held by a taxpayer, whether or not connected with a trade or business, is considered a capital asset, except for stock in trade, inventories, real property used in a trade or business, intellectual property in the hands of its creator, accounts receivable, and commodities derivative financial instruments in the hands of recognized dealers in said instruments. Excepted property is considered a non-capital asset. The most relevant difference between the two is that proceeds from the sale or exchange of capital assets enjoy capital gains treatment under certain circumstances. However, disposals of capital assets are also subject to capital loss limits – currently the lesser of $3,000 or the amount of offsetting capital gains per year for individuals (corporations are not subject to the $3,000 limit, but are subject to the offsetting gains limit).
The Internal Revenue Code does not recognize commodities as a separate class of asset. Commodities (or usually the option or forward contracts that represent them) are capital assets to individuals other than brokers and dealers (to whom they are non-capital assets). Under almost all circumstances, the description of Bitcoin as a “commodity” by the IRS would cause it to be a capital asset to an individual. Bitcoins received in connection with a trade or business would still be treated as ordinary income at the time of receipt. Gains or losses realized later under this scenario would receive capital gain/loss treatment.
Taxpayers who either hold Bitcoin long term or who trade Bitcoin in order to take advantage of the volatility and who are not commodities brokers/dealers may be in a position for their income to be treated as a capital gain instead of ordinary income. In order to take the capital gain rate, taxpayers must be prepared to show that they held the associated asset for at least one year – not an easy task for Bitcoin, even when traders are careful with their record keeping. There is a technical reason that this may not even be possible for most Bitcoin traders: in the interest of efficiency, the Bitcoin protocol deliberately uses the smallest blocks of coins possible when a transfer is recorded. This means that investors can neither control nor even determine which lot or lots of Bitcoins were traded at any given time. Nevertheless, the IRS may ultimately allow either some form of synthetic lot tracking or the use of an inventory method such as FIFO or LIFO for calculating gains. Refer to the first part of this series for information about maintaining proper records.
Since January 1, 2011, brokers have been required to report transaction information by lot to the IRS each year on form 1099-B (and provide this to their customers at tax time). Bitcoin doesn’t presently have brokers to keep up with this information or report it to the IRS, though it is not unlikely that the exchanges would eventually be required to report this information if Bitcoin endures.
The IRS may not have figured Bitcoin out yet, but most of the situations encountered by individual and business taxpayers when dealing with Bitcoin are readily comparable to other types of transactions for which an extensive body of governing regulations and case law already exist. Until the regulations for virtual currencies are written and released, Bitcoiners remain free to choose how and when to report gains at tax time. As long as the position taken is reasonable under the circumstances and is consistently applied, taxpayers would be well advised to select the position that results in the lowest overall tax burden.
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