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.
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.