The IRS Isn't Sure How Bitcoin Will Be Taxed

As the sudden demise of Coinye West showed, death still applies to the world of cryptocurrencies—but do taxes?

Yes, eventually Bitcoin may be mainstream enough that citizens will need to report their earnings and transactions to the feds. Whether or not they actually do is another question, as Bitcoin was designed to subvert the existing financial system. But how would taxing it even work, assuming holders would cop to making purchases or trades with it?

The tax rules for online currencies, originally drafted for virtual worlds like "Second Life," are pretty dated, which prompted the IRS's national taxpayer advocate to ask Uncle Sam to clarify them. The key question the IRS needs to address, according to the NTA's 2013 Annual Report to Congress, is whether or not cryptocurrencies such as Bitcoin are in fact currencies in the feds’ eyes, or some other kind of financial instrument, like stocks and gold.

The reason this distinction is important is because currencies and regular income are taxed much more heavily by the IRS than capital gains—which are used primarily for stocks, real estate, and commodities. That’s true at every income level, but especially at the lower end.

For example, someone with a taxable income of $85,000 would end up paying about five percent more tax on that income if Bitcoin is treated as a currency than if it were treated as a capital gain, per the Wall Street Journal's handy chart. On the lower end of the scale, someone with a taxable income under $36,250 doesn’t pay any tax on investment activity, whereas regular income would be taxed between 10 to 15 percent. Even for the rich, it’s still advantageous, as someone earning a taxable income of $399,000 would pay a regular income tax rate of about 35 percent, versus the capital gain tax of 15 percent.

If being assessed a lower tax rate wasn’t enough of an advantage already, treating Bitcoin and its ilk as capital gain income would also allow cryptocurrency traders to use a range of creative accounting techniques to offset gains, which lowers the total amount of tax owed, and they could even potentially dodge some taxes altogether.

But treating Bitcoin entirely as a capital gain is probably not going to happen. Despite being dated, the current IRS guidance for virtual currencies still offers useful insight into the agency's thinking. Originally, the IRS developed the rules for “online games” with “characters called avatars” (otherwise known as massive multiplayer online games, like World of Warcraft). According to the tax documents, you can receive income from virtual worlds as “money, property or services” and if that amount exceeds what you spend, you “may” be required to report the gain as regular taxable income, the document states.

Bitcoin, along with other cryptocurrencies, indeed present unique challenges in regards to taxation that the IRS will need to address thoughtfully. Mining is one of the most obvious examples. It costs energy and equipment to mine Bitcoin, much like regular mining operations. But, unlike traditional mining, the product is not clearly a commodity, which makes the question of business deductions a gray area. To look at it in analog terms, the US tax code does not currently have framework for the costs of printing money.

Mining for Bitcoin is only one example of how the cryptocurrency’s unique properties make assigning a single definition or rule to govern their taxing an unwise idea. What might make more sense—although it’s hard to know if that makes it more likely to happen—is that the IRS will assign different tax rules to operations like mining, currency speculation, and buying and selling goods and services.

The point is that one way or another the IRS needs to tell the taxpayers whether Bitcoin and other cryptocurrencies are stores of value, like gold, some kind of investment instrument, or just plain old money.