Bitcoin Series 25: IRS Bitcoin Tax Guidance - Transacting With Commodity Money

 IRS Field Office, New York.  Source:  Wikimedia Commons

IRS Field Office, New York.  Source: Wikimedia Commons

This is a a quick 1st reaction note on the recent IRS tax guidance on Bitcoin.   Please note that I am not a tax lawyer and certainly not your tax lawyer so treat accordingly.  

Overall

For the most part the guidance was exactly as expected and can be summarized by the following principle:  

If an activity is taxable and reportable in US dollars, then it is taxable and reportable when the same activity happens in Bitcoins.

This is logical and sensible and consistent with long-standing tax principles, namely that the form of compensation does not matter, just the amount of compensation.  

If you think about this for a moment, you understand that it has to be this way, otherwise you leave an open hole for people to arbitrage the tax system by paying employees, vendors and investors in non-taxable, non-reportable gold, cars, house, fine wine and so on.

Implications of Treating It As Property

The part in the guidance that, at first glance, seems quite problematic and unusual rests at the intersection of treating bitcoin as property and general consumer transactions where it is used much like currency is.  

The problem this creates is that every time you buy something with bitcoin, you are creating a 'realization' aka a sale of property under the new IRS guidance.   That means that you need to calculate (a) if you have a capital gain or a capital loss, which itself means that (b) you need to know how much you sold your bitcoins for and (c) what was your 'basis' in those particular bitcoins (aka how much did they cost you) (d) which is a whole other exercise is figuring out which coins to allocate to that transaction.

Let's start with a very simple non-Bitcoin example to make this clear:

Jan 1, 2014:  I buy a Warhol tomato soup can print for $50K (this is my basis)
Jan 1, 2015: I go to a Tesla dealer and buy an $80K Tesla with my Warhol print.  

My 'functional currency' for filing taxes in the US is US dollars so I can't submit a tax return denominated in Warhols and Teslas (or Bitcoins) - it has to be converted back to USD.

So, specifically, I have a 'realization' on my print, namely I sold it for $80K.  The fact that I collected my $80,000 in a Tesla as opposed to in cash is irrelevant.  I need to recognize a capital gain of $30K and pay taxes on my good fortune. In an alternative universe, where I sold my Warhol for a $20K Kia, I would recognize a capital loss of $30K and get capital loss treatment.

This works generally OK for most property because most property is large enough that these transactions happen rarely.   Nobody shows up at the grocery store with fine art, gold, pork bellies and so on to try to buy a loaf of bread.  

In Bitcoin however, you might end up with somewhat absurd looking capital gains transactions like:

Bought 0.1 BTC for $100

Used 0.002 BTC for coffee worth $2.15, therefore time to recognize a $0.15 capital gain.

How Did  IRS  Get Here?

I have no special insight into the IRS's thinking here, but here is my guess on how they got here:

(1) Clearly if you buy a Bitcoin for $500 and sell it a year later for $1,000, logic would suggest that you have a taxable gain of $500.   The IRS is concerned is that you might instead trade it for a $1,000 TV and avoid the capital gains.

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(2) Bitcoin isn't some foreign land where people go to rarely. Instead, it rests in parallel to our USD denominated economy so it could get big.

Let's imagine instead you went on a trip to France.

You change 130 dollars for 100 euros

While you are flying, the rate changes and 100 euros now buys you 140 dollars back in the US.   By applying the same logic as for Bitcoin, when you go for a 100 euro French dinner with your 100 euros, you should be recognizing a $10 capital gain because that dinner is now worth $140 (but you only paid $130 for it.)

In reality, this issue is ignored completely for individuals because it is self-minimizing in practice since how many dinners in France is the average consumer going to have?* and handled under a totally different (and arcane/complex regime) in corporate financial statements.

* I think the law technically says that gains of less than $200 on foreign currency for individual/personal transactions are non-reportable.  

One could have imagined the same treatment for Bitcoin but given that it is easy to transact with Bitcoin from the comfort of your own home, perhaps they did not want to give that exception (or did not want to treat Bitcoin under the foreign currency rules altogether).

Something New

The whole awkwardness of existing frameworks comes from the fact that Bitcoin is somewhat new in a modern economy.  It really is a form of commodity money where it serves the role of commodity and money simultaneously so no framework fully covers it.  

That is why FinCen says 'wait, this smells like money, I need AML applied' and IRS says 'this smells like a commodity, I want my capital gains taxes'


Technology to the Rescue?

Let's assume that this guidance stands for now.  If Bitcoin were an old-fashioned paper currency, this would be a Game Over situation.   Nobody would be sitting there calculating capital gains every time they buy a coffee.

However since Bitcoin is all-electronic, all-public, all-standardized, all-24-7-365 traded, I think the mechanics of this will be managed fairly trivially via technology.

Imagine that hosted wallet providers (or multi-wallet tax software for the fancier folks), simply track all your inputs / outputs from your wallet, pulling a market price in USD (or the functional currency of your choice) at the time of each transaction.  

At year end, it could pick from a variety of frameworks to calculate basis (aka which coins to allocate to which transactions) in order to minimize taxes (if any) and then produces the type of 1099 statements you already get from your bank or investment firm.

While this adds a bit of an educational burden to consumers, I think the mechanics are very manageable.  The fact that a couple of months of smart coding will put this issue to bed will be an awesome demonstration of the leverage one gets when all financial transactions are natively electronic.

Those are my first thoughts.  Comments very welcome.

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Posted on March 25, 2014 and filed under Bitcoin.