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

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.

plus

(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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There are more recipes than atoms in the universe. What does this mean for your life, career and dinner?

Fresh ramen noodles, pork belly marinated in sake, mirin and soy, sous-vided and then deep-fried, chives, extra-spicy Szechuan sauce (itself consisting of: fermented salted soybean, water, salt, wheat flour, chili, sugar, pickled vegetables, soy bean oil, garlic, salt, peanut, onion, sesame oil, yeast extract, maize starch), sous-vided egg marinated in juices from the pork belly, jalapenos, mayu (blackened garlic in sesame oil), bean sprouts, blanched bok choy and blanched Shanghai choy.

All of above, now with 12 hour Tonkotsu broth made from pig bones, pigs feet, a whole chicken, garlic, charred garlic, ginger, charred ginger, onions and chives poured on top of it.

The Joy of Cooking

I enjoy cooking.  Part of it is because it allows you to eat tasty things at home, but part of it is because it is a puzzle of sorts.   What ingredients, in what order, in what relative quantity, with what pre-treatment, with what cooking technique are likely to produce something that is tasty, nutritious, both or neither, is a non-trivial problem.

The other day I was thinking about exactly how non-trivial the problem, in particular "how many recipes theoretically exist?" and came to the astonishing conclusion that there are far more potential recipes to try than there are atoms in the universe and that, short of some post-Singularity food modeling, we humans, in aggregate, will never cook more than an infinitesimally small fraction of all recipes that can be cooked.

I will run through some quick math of how to calculate the Total Recipe Space, noting that I believe every number here is wildly underestimated.

How many potential ingredients are there?  

I am assuming for my calculation that there are 200,000 ingredients in the world.   This is a huge understatement.

The average suburban supermarket sells ~40,000 items and anyone who has traveled abroad knows that there are still very large distinctions in what type of food is carried in supermarkets in Nashville, Nice, Nicosia, Nagpur or Nanjing.

Beyond that, what you realize is if you start digging deep into any specific food area, is that there are variations upon variations upon variations.  An elite sushi chef will differentiate between many different parts of a tuna, differentiate between warm-water and cold-water tuna, between younger and older tuna and so on, at which point one comes to the conclusion that there are probably 50,000 different cuts of fish, each with different tastes, consistencies, textures and cooking properties.  The same thing holds for any other food group once you start studying intently.  I have read, for example, that there are 75,000 wines in production in the world right now.  

But for the purposes of this exercise, we will stay with 200,000 potential ingredients, even though I suspect that the total number of unique ingredients is well into the millions.

How many ingredients go in a recipe?  

I am going to base my estimates on assuming 10-ingredient recipes.   I have read that 8 ingredients is average in a recipe, but it is trivial to go above 8.  Fajitas with salsa and guacamole, a generic Tex-Mex dish easily surpasses that, to say nothing of complex or engineered foods.   The ramen above had nearly 40 ingredients in it.   

Each additional ingredient assumed above 10, adds about 7 orders of magnitude to the final number as you will see below so these figures are also an underestimate because we know that there are recipes with more than 10 ingredients.

What are the relative quantities of ingredients used?

A recipe with 1lb of pasta and 1lb of garlic is different than one with 1lb of pasta and 1oz of garlic.

For the purposes of this exercise, let's assume that there are 10 possible quantities of each ingredient so our 200,000 ingredients become 2,000,000 ingredients.  Again, this is also a simplification.

What are the preparing, cutting and cooking treatments of each ingredient?

Recipes are more than simply put each of the ingredients in a bowl and serving them.

They might be chopped into different sizes (Chinese cuisine has dozens of variations of chopping size alone), they might be grilled, sauteed, boiled, blended, mashed, mashed+grilled, grilled rare, medium rare or very well done, glazed, sous-vided, broiled, steamed, cooked in the wok (itself many different variations), put in a clay oven and so on.

And again the results differ:  raw garlic is different than sauteed garlic which is different than minced garlic which is different than grilled garlic which is different than blackened garlic which is different than ground garlic which is different than oven-roasted garlic and so on.

Let's assume that there are 10 methods of preparation for each ingredient which is definitely a dramatic understatement (the real number is probably closer to 100-200, if not 1,000).

In any case, with 200,000 ingredients in 10 different portion sizes and 10 methods of preparations, we have 20,000,000 building blocks to work with.   If we wanted to be more aggressive, we could imagine 2,000,000 ingredients with 10 portion sizes and 100 methods of preparation and start with 2 billion building blocks.   In any case, we will start with the 'conservative' case.

Factorials!

Using the factorials we learned in high school math, it means that the possible number of 10-ingredient recipes is:

20,000,000 x 19,999,999 x 19,999,998 x 19,999,997 x 19,999,996 x 19,999,995 x 19,999,994 x 19,999,993 x 19,999,992 x 19,999,991 = 

10,239,976,960,022,300,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 

potential 10-ingredient recipes.

Or, 1.02 x 10^73 if I counted my zeros correctly

And if I took less conservative estimates above, we might be multiplying 2,000,000,000 x 1,999,999,999 and so on in which case we are talking about about 1.02 x 10^93 or this for those who are counting at home:

1,023,997,696,002,230,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 

Note 1: Since the order of ingredients matters in recipes, we do not need to divide by 2

Note 2: Some might argue that there are logical parts of the Total Recipe Space that are unpalatable and should be excluded: e.g raw beef tartare + onions + strawberries + tuna + cheetos + doritos + bacon + kale + yogurt + oatmeal is probably not tasty.

I will note that:

(a) that is true but this is a calculation of all possible recipes (not necessarily recipes that you would like)

(b) Fusion chefs have created some very tasty food out of very unlikely combinations and there are certainly many unexplored delicious flavor combinations that we do not know about yet.

(c) Even if that is the case, the more aggressive estimates that add 20 or more orders of magnitude would more than account for this problem.

How big is 10^73?

So, let's put that 1.02 x 10^73 figure in context.   

(a) I have seem estimates that the total number of people who have ever lived is 100 billion.

Let's be super generous and imagine that every man, woman and child who ever lived knew 50 unique recipes and that each of those recipes were unique to that person - aka no two people ever cooked the same dish.

That places the total number of world recipes ever cooked at 5 trillion or 61 orders of magnitude (61 zeros) less than the  Total Recipe Space.

(b) There are supposedly 9.48x 10^61 atoms in the known universe or 12 orders of magnitude fewer than the Total Recipe Space (conservative estimate).

So that means, even with lots of 'fusion' restaurants, humanity will never explore even a small fraction of the Total Recipe Space (unless we get to post-Singularity intelligences that model food tastes and cook recipes 'virtually').   If every man, woman and child alive today made a new recipe for breakfast, lunch and dinner for each day of his/her 80 year life, we only get to 6.13 x 10^14 number of recipes.

What this means for life, liberty and the pursuit of happiness?

(1) If you are fusion chef, keep experimenting!  Please.  For the good of humanity itself - you might discover the next tuna tartare-avocado combination that will spread around the world

If you are a restaurant-goer, be kind to those chefs who try new things.   They are the startups of the food world and they are doing us all a service by expanding into new parts of the Total Recipe Space.

(2) I have read statistics that claim that the average family repeats the same 6 to 12 recipes.  

If you cook at home,. you might consider, in this context, there there might be room to expand your mix of recipes!

(2) If there are 1 x 10^73 choices for dinner, imagine how many choices you have about how to live your life in which every moment you are deciding what to think, what to say, what to do and where to go?  

Be bold.  Don't just do what you think you 'ought to'.   All of the humans who have ever lived have barely scratched the surface of "what's for lunch?" let alone how you should live your life and what you should do for your career, for your personal life, for your family and for love.

So step out into that broader world and help us all expand the scope of human knowledge and experience, one step, one idea and one recipe at a time!

Bitcoin Series 24: The Mega-Master Blockchain List

The Mega-Master Blockchain* List
Draft / Work-in-Progress / Not totally consistent in its categorization

This "Twitter-sourced" list (started March 11, 2014) is an open/rough attempt to brainstorm what asset registries, keys or related items theoretically could be implemented in a blockchain model. They may or may not be good ideas to do in a blockchain or might be good in certain circumstances or others, but that is not this exercise - this is a brainstorming exercise.

* Either the bitcoin blockchain or alternative blockchains

What is missing?  Tweet it to: @polemitis

          I. Financial Instruments, Records and Models

1. Currency

2. Private equities

3. Public equities

4. Bonds

5. Derivatives (futures, forwards, swaps, options and more complex variations)

6. Voting rights associated with any of the above

7. Commodities

8. Spending records

9. Trading records

10. Mortgage / loan records

11. Servicing records

12. Crowd-funding

13. Micro-finance

14. Micro-charity
    
    II. Public Records
     

15. Land titles

16. Vehicle registries

17. Business license

18. Business incorporation / dissolution records

19. Business ownership records

20. Regulatory records

21. Criminal records

22. Passports

23. Birth certificates

24. Death certificates

25. Voter IDs

26. Voting

27. Health / Safety Inspections

28. Building permits

29. Gun permits

30. Forensic evidence

31. Court records

32. Voting records

33. Non-profit records

34. Government/non-profit accounting/transparency
    
    III. Private Records
    
     

35. Contracts

36. Signatures

37. Wills

38. Trusts

39. Escrows

40. GPS trails (personal)
    
    IV. Other Semi-Public Records
    
     

41. Degree

42. Certifications

43. Learning Outcomes

44. Grades

45. HR records (salary, performance reviews, accomplishment)
46. Medical records
47. Accounting records
48. Business transaction records
49. Genome data
50. GPS trails (institutional)
51. Delivery records
52. Arbitration
    
    V. Physical Asset Keys
     
53. Home / apartment keys

54. Vacation home / timeshare keys

55. Hotel room keys

56. Car keys

57. Rental car keys

58. Leased cars keys

59. Locker keys

60. Safety deposit box keys

61. Package delivery (split key between delivery firm and receiver)

62. Betting records

63. Fantasy sports records (!)
    
    VI. Intangibles (?)
     

64. Coupons

65. Vouchers

66. Reservations (restaurants, hotels, queues, etc)

67. Movie tickets

68. Patents

69. Copyrights

70. Trademarks

71. Software licenses

72. Videogame licenses

73. Music/movie/book licenses (DRM)

74. Domain names

75. Online identities

76. Proof of authorship / Proof of prior art
    
    VI. Other
     

77. Documentary records (photos, audio, video)

78. Data records (sports scores, temperature, etc)

79. Sim Cards

80. GPS network identity

81. Gun unlock codes

82. Weapons unlock codes

83. Nuclear launch codes (!)

84. Spam control (micro-payments for posting)

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Bitcoin Series 23: Bitcoin Disclaimer

This disclaimer regarding bitcoins has appeared in a few of our posts.    Here we are posting it by itself so it can be easily referenced at:  ledracapital.com/btcdisclaimer

1. We do not care if you buy bitcoins
    

2. We are not a broker-dealer, broker, financial advisor or licensed in any jurisdiction, in any way to give you financial advice
    

3. This is most certainly not a recommendation to buy, sell, short, trade bitcoins, litecoins, bbqcoins, dogecoins or StalwartBucks – you could lose all your money in one of many ways including, but not limited to: your incompetence, poor security, poor backups, poor trading strategies, price fluctuations, pump-and-dump schemes, software bugs, counterparty risk, exchange rate risk, liquidity risk, regulatory risk and more!
    

4. If you choose to buy bitcoins or any other cryptocurrency, you are 100% buying it at your own risk and on your own initiative.   In any case, you will not be buying it from us because we are not in the business of exchanging cryptocurrencies.
    

5. Bitcoins are not anonymous and exchanges and online wallets even less so.   If you are going to use bitcoins to try to cheat on your taxes / divorce settlement / child support, you are a moron.
   
   Pro tip:  If you think you have discovered a great business opportunity that involves trading cash/gift certificates/other stores of value in/out of bitcoins, run to your lawyer's office and ask him or her to explain to you what AML, KYC, MSB, BSA and "sentencing guidelines" mean.
    

6. If we reference a firm in the bitcoin space it does not mean that there aren't other firms that might do the same thing better / in your country.    
   
   Moreover, referencing a firm is in no way an endorsement of that particular firm – any firm theoretically could be hacked, run away with your money or be shut down by regulators / co-opted by the ‘system.’ 
   
   Keep in mind that most firms in this space are still very young and very small relative to traditional financial institutions.   You likely do not have the same level of consumer protections that have been developed over the course of decades in banking at this point.
    

7. We may or may not invest in any particular sector of the cryptocurrency field.
    

8. Ledra Capital, our affiliates and our principals may hold any number of old-timey 'fiat' or digital currencies at any time long, short or falling out of our wallet all crumpled up after a long night of drinking.   If we knew how different sovereign and/or virtual currencies would trade against each other in the future, we would be having umbrella drinks on our private islands, not tweeting about bitcoin.   
    

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