Why the IRS Is Taxing Bitcoins as an Asset

The IRS taxes Bitcoins as an asset rather than a currency. Is this a clever move that could stabilize the currency, or is this the opening salvo in a battle that it’s doomed to lose?

Mar 26, 2014 at 11:31AM

The U.S. government recently took its first steps in regulating Bitcoin, the world's top cryptocurrency, but it wasn't through the tighter regulation of its exchanges and businesses. Instead, the IRS announced that Bitcoin and other virtual currencies will be taxed as a property and not as a currency.

In other words, Bitcoin is now the same as a stock, bond, or real estate for tax purposes, and would be subject to capital tax gains when sold at a profit. Therefore, any payments received in Bitcoins and all personally mined Bitcoins now need to be reported to the IRS through forms W-2 or 1099 and taxed accordingly.

Images

(Source: Flickr)

By comparison, if Bitcoin were treated as a regular foreign currency, only ordinary tax rates, not capital gains taxes, would apply. For example, if you purchase a $4 slice of pizza for Bitcoins originally acquired for $2, it will trigger $2 in capital gains for you and $4 in gross income for the pizza shop. Add local sales tax into that equation, and you get a messy calculation that makes a simple cash transaction seem more reasonable.

According to the new IRS regulations, Bitcoin capital gains will be taxed at lower rate if held for a longer period of time, with a maximum rate of 23.8% for long-term gains and 43.4% for short-term ones. The new rule allows U.S. taxpayers to write off their losses from failed Bitcoin exchanges as capital losses.

What's the government's strategy?
The government is approaching Bitcoin from two angles.

First, taxing transactions of Bitcoin, which has risen more than 500% over the past year, could be a good way to grow the government coffers. The government has already started cracking down on overseas transactions with the Foreign Account Tax Compliance Act (FATCA), which requires foreign financial institutions to report the holdings of their American clients to the IRS. Since Bitcoin is gaining ground as an anonymous currency without borders, the IRS is clearly concerned about the potential loss of tax revenue.

Second, Bitcoin has been implicated in money laundering and sales of illegal drugs in online black markets like Silk Road. Therefore, it would make sense to throttle the adoption of the virtual currency by slapping every transaction with tax forms.

Reducing the volume of transactions could also reduce Bitcoin's volatility -- a key hurdle that keeps it from being accepted as a mainstream currency.

Is the IRS naive to think virtual currency taxes will work?
High profile Bitcoin-accepting businesses -- such as Overstock.com (NASDAQ:OSTK), Tesla (NASDAQ:TSLA), and Virgin Galactic -- will naturally adhere to these new laws.

However, Bitcoin has already gained a reputation as a currency without international borders. Much of Bitcoin's appeal stems from the fact that it isn't a fiat currency backed by any government -- it's a self-sustaining algorithm that will eventually allow the last Bitcoin, out of 21 million possible coins, to be mined by 2140.

Bitcoin can be effortlessly transferred through mobile devices, Internet connections, and kept in online "hot wallets" or offline "cold storage" such as hard drives or physical coins. They can also be mined from home with pooled processing power and Bitcoin miners. Since Bitcoin is more anonymous than cash and can be transferred in such a wide variety of ways, how can the IRS ensure that all Bitcoin transactions are taxed?

Democratic Senator Tom Carper stated that the IRS guidance "provides clarity for taxpayers who want to ensure that they're doing the right thing and playing by the rules when utilizing Bitcoin and other digital currencies." In other words, the government is somewhat relying on an "honor system" in which Bitcoin investors, vendors, and miners willingly report their transactions.

However, the government could be easily outgunned in terms of technology. The recent implosion of three Bitcoin exchanges (Mt. Gox, Flexcoin, and Vicurex) indicate that the ones moving around the most Bitcoin clearly have the technology to evade detection.

The bottom line
In my opinion, there's no feasible way for the IRS to tax all Bitcoin transactions, since many of those exchanges are located overseas -- which means the most likely way to get taxed is to report the transaction. It's also nearly impossible to tax a miner at home unless the mined Bitcoins are voluntarily reported to the IRS.

Naturally, people with capital losses will report their transactions, but it's doubtful that the new regulations will make much impact on the average Bitcoin investor. Instead, the IRS will go after the whales first, such as venture capital firm Andreessen Horowitz's recently disclosed $50 million in Bitcoin holdings.

Although the U.S. government might have trouble tracking all Bitcoin transactions across the country, Bitcoin investors should still familiarize themselves with these new rules to avoid being audited in the future.

Take advantage of this little-known government tax rule
Recent tax increases have affected nearly every American taxpayer, even Bitcoin investors. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Tesla Motors. The Motley Fool owns shares of Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers