If you do not already have a Bitcoin exchange account, you have likely heard of—and been confused by—the Bitcoin phenomena. In short, a Bitcoin economy looks very much like the Dollar economy—the most obvious difference being that you can’t touch or feel a Bitcoin. Bitcoins are strings of numbers and letters containing both a private and a public “key” and exchanged between Bitcoin wallets through parties’ pairing of the two keys.You can “earn” Bitcoins by installing mining software on your computer (the software then solves complex algorithms and, if it solves a difficult equation, Bitcoins are deposited into your Bitcoin “wallet”). If you do not have the mining equipment, you can purchase Bitcoins with Dollars or any other “real currency” on virtual exchanges. Like a Dollar, Bitcoins can be used to purchase virtual or real-life commodities or sold for “legal tender” like the Dollar or Euro.
Bitcoin transactions present a Pandora’s box of tax issues:
- When does a Bitcoin transaction trigger gain or loss recognition?
- Must Bitcoin accounts be reported in the same manner as Foreign Bank and Financial Accounts?
- What method of accounting should be used to calculate gains?
- Are you required to withhold amounts paid in transactions with foreign Bitcoin holders (and if so, how do you determine whether the account holders are foreign)
- How should transactions be reported?
- Are gains taxed as ordinary income or capital gains?
There are now approximately $12.6 BILLION Bitcoins in circulation and despite their and other virtual currencies being in circulation for a number of years and the IRS’ recognition that guidance is needed, the IRS has not issued any guidance on the issue. So far, the Service has only linked questions concerning virtual transactions to information on its website for information on such things as bartering, gambling, business, and hobby income. Only the IRS could be so creative as to answer a question by referring the inquirer to the inquiree’s prior answer on a different topic…
So as we head into tax season, in analyzing the tax consequences of Bitcoin transactions, where should a Bitcoin account holder start?
Perhaps one approach to answering virtual currency-related questions is to first consider the difference between a Bitcoin and the Dollar itself. When the “gold standard” was eliminated in 1971 and a paper U.S. dollar no longer represented a piece of a gold brick in Fort Knox, the only thing remaining that made it worth more than the paper it was printed on was a government declaration that it was “LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.” Thus, since 1971, the Dollar has been a “fiat currency”: a government-declared legal tender that does not represent a physical commodity.
The only thing making a Dollar “legal tender” is a Government declaration, and thus practically as “virtual” as a Bitcoin itself. As our familiarity with technology-assisted transactions increases, conceptually the difference between a Bitcoin and a Dollar transaction narrows.
What is without question, however, is that a Bitcoin transaction is just as real as a post-gold standard Dollar transaction. So if a Dollar is a Dollar is a Dollar, is a Dollar a Bitcoin?
Just ask a Bitcoin holder when he wants to spend his.