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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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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Bitcoin Series 22: Bitcoin Valuation for Dummies

A market in Tengeru, Tanzania.  Source: Wikimedia commons

[updated: Some people apparently not familiar with the "For Dummies" reference - it was/is a popular series of reference books in the US - not pejorative. :) ]

Sorry to disappoint both bulls and bears but there will be no price targets here, just the theory about when and why bitcoin has a non-zero price.

Three steps to a bitcoin price:

1.  Imagine any usage case (international peer-to-peer remittances, micropayments, machine-to-machine transactions, holding some value outside of the existing financial system, etc) where BTC turns out to be useful.   It does not matter what the usage cases are at this stage - for the basic analysis to hold there just has to be at least one usage case that sticks.  

2.  Please note that (a) you need bitcoins to engage in these usage cases, (b) you don't have any bitcoins, (c) other people do have bitcoins and (d) the supply of bitcoins is mathematically limited.

Moreover:  If an application works in bitcoin, the fact that you own, say, litecoins or dogecoins is not necessarily helpful because most apps will support 1 or 2 'coins' at most.   So competition between alt-coins has very little do with minor differences in their implementation algorithms, but with how many applications are built on top of each one.   Though this could change, bitcoin has a tremendous head start in this regard.

3.  Given #2, you need to go buy bitcoins from others.   At this point, we have a buyer, a seller and market and, since there is no holding cost to a BTC, a price definitionally above $0.00.

Three basic conclusions:

4. The only thing that matters to BTC's valuation is how many real-world usage cases emerge for BTC.   If there are dozens, it will fulfill the dreams of its evangelists.   Conversely, the bear/ponzi case that value is $0, is another way of saying "there is no context anywhere on the planet that BTC will be useful" because there is no other scenario in which price hits $0.

5. Bitcoin is an open system so every developer/VC on the planet has the economic incentive and ability to discover real-world usage cases for it.

6. To conclude that the current financial and payments system (that still has us using plastic credit cards and banking phone apps that *have us take pictures of a paper check* to deposit it) has exhausted all financial innovation possibilities for our online, robotic software-eats-the-world of 2025 is a profound lack of imagination, in my humble opinion.

Unknowns

Of course, there are many unknowns in the above:

7.  If and when the usage cases will develop

8.  If they will be hindered by governmental regulation and competitive lobbying from the current payment processors 

9.  If superior forms of bitcoin will emerge.   One form that might be theoretically better (but a long way from being imminent) would be a FedCoin.

Bulls and Bears
In the context of the above, you can see why very smart people have such wildly divergent reactions to bitcoin:

10.  If you are a traditional consumer financial services executive (or reporter) where innovation has been measured over the scale of decades, a new currency that seems a bit shadowy, risky, volatile, and not clearly cheaper to use for domestic transactions sounds like a loser.

And so the fact that this loser thing has a $5-$10B 'market capitalization' or 'money supply,' sounds like the very essence of mass delusion and a 'bubble'.   Someone, somewhere must be tricking someone with a ponzi scheme for this to be happening!

One might kindly argue to you that this view is too focused on a specific point in time (today!) rather than the rate of change.

11. If you are VC/developer/futurist whose business is focused on successfully extrapolating trend lines, then bitcoin looks exactly like the type of thing that leads to epic riches: 

(a) It has an extraordinary rate of growth on every dimension - in four years, it has gone from a 'white paper' for the love of god to millions of users and better-than-price-competitive merchant processing (even with volatility hedged out) than merchant processing platforms that have taken decades to built.  

(b) It is an open protocol with no central point of failure.  Protocols of this type have historically been huge wins in technology because they foster innovation that was completely unimaginable to their inventors (aka TCP/IP).

(c) It is completely consistent with general tech trends - more economic activity is moving to online, machine intermediated, global and decentralized modes of delivery.   Bitcoin and the like are very well suited to that environment.

So, to a tech brain, the concept that bitcoin or other cryptocurrencies might facilitate 1% of global transactions in 2025, including whole classes of transactions that don't exist today like machine-to-machine payments, seems perfectly plausible.    In that model, bitcoin today is vastly undervalued.

Summary

Most of the online discussion about the valuation of bitcoin is misguided.   If you are using any of these phrases in your argument, you are doing it wrong:  "ponzi scheme", "the evils of paper fiat currency," "did the price move today?," "going to the moon,"  "is bitcoin dead?" 

Bears of the 'going to $0' variety should make the case that 'BTC will have no applications' and that the current system will fill in the gaps just fine.   That is a pretty confident statement...and usually an intellectually lazy statement.

Bears of the 'going to $50' variety should explain their thought process about what applications they are assuming, what market share gains they are assuming and so on.     

Bulls of the 'going to $50,000' variety should making a case about exactly what applications of the financial system BTC will be able to take over and be better than the current system (on a fully loaded cost basis, including consumer friendliness, security, etc).

And even when all that is done, you will realize that a large part, if not the majority of bitcoin's current valuation, is based on 'potential applications that have not yet fully developed' as opposed to 'activity occurring today.'

In this regard, it trades exactly like any mid-stage VC-backed company that has super-duper growth rates, with the difference that you are making a bet that 'someone, somewhere will invent good usage cases' as opposed to betting on a single management team (this is deeply underappreciated).   In other words, the currency is, in some ways, an ETF on the entire field.

Disclaimer

And because people are silly, our usual disclaimer applies:

(1) We do not care if you buy bitcoins (2) We are not a broker-dealer, broker, financial advisor or licensed in any way to give you financial advice (3) This is most certainly not a recommendation to buy, sell, short, trade bitcoins, litecoins, bbqcoins or StalwartBucks – you could lose all your money in one of many ways including, but not limited to: your incompetence, poor security, poor backups, software bugs, counterparty risk, exchange rate risk, liquidity risk , regulatory risk,  and more! You are 100% buying bitcoins at your own risk and on your own initiative. (4) 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. (5) These are not the only ways to buy bitcoins (just some of the more popular ones) nor are we endorsing these companies – any of them theoretically could be hacked, run away with your money or be shut down by regulators / coopted by the ‘system’. (4) Ledra Capital, our affiliates and our principals might hold any number of old-timey 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 they 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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Bitcoin Series 21: BTC, Retirement Plans and IRAs

Louisiana Baby Bonds, circa 1880.  Source: Wikimedia Commons

Today I was invited to help give a Continuing Legal Education presentation on "Retirement Plan and IRA Investment in Bitcoin and other Cryptocurrencies" for the Practicing Law Institute being taught by two of the top benefits lawyers in the US,  Arthur Kohn of Cleary Gottlieb and Howard Pianko of Seyfarth Shaw.  Amusing tidbit: Howard wrote the "Pianko Letter" that generated the guidance for futures contracts under ERISA back in 1982.

Some observations from the call:

1.  There are plenty of regulations across all parts of the financial systems that already apply to bitcoin.   Just like with AML/KYC laws for money service businesses, if cryptocurrencies are to interact with retirement plans, there is a whole set of regulatory issues that must be thought through.  As was said in the Senate hearings last year relating to AML and KYC regulation, it makes a lot of sense to see if the existing legislation can be interpreted in order to adequately manage cryptocurrencies before worrying about adding new legislation.

Bitcoin is an incredible technical breakthrough, but in many financial and economic domains, there are already frameworks, laws and principles that can be used to think about it.   

2.  This is a complex and subtle topic.  We spent hours before and during the call trying to see which framework (currency, commodity money, intangible, contract, collectible) fits different aspects of each regulation as it applies to bitcoin.   We definitely made some progress, but even with two very knowledgeable experts in the room, there was still room for disagreement and spirited debate. 

3.  The thorniest topic actually falls under ERISA and has to with the 'indicia of ownership' standard aka how do you prove you own the bitcoins and they have nexus to the US (a requirement under the regulations).  

Certainly you can demonstrate that you have the private key (that part is easy), but how do you demonstrate that nobody else does?  You might consider that bearer instruments are a good analogy but there the indicia are clear -- whoever physically holds the bearer bond owns it.   By contrast, any number of people can have a copy of the private key without that being obvious.   I personally suspect the answer lies somewhere in the direction of multi-signature transactions and formal custodians, but this needs work and, ultimately, some standardization.  

This is a question that will come up again and again.   For example:  how does a hedge fund undergoing its annual audit prove to its accounting firm that it is, in fact, the *sole* owner of 53,432 bitcoins?

4.  The registration attendee list was something like 40% big name law firms, 40% FT 500 firms, 20% regulators.  There was only one BTC firm listening in. 

I believe there is absolutely a need for BTC firms to be reaching out more aggressively to the existing financial services field and, IMO, forming a cross-disciplinary group (BTC technical experts, financial services executives, lawyers, accountants) to be working on these issues and providing best practice recommendations and guidelines to regulators and other related parties (aka auditors).  

Each side needs expertise from the other side in order to get to the right answer and, without everyone in the room, silly mistakes will be made and/or poorly drafted regulations will be written.

I am including the presentation in case you are interested.   The written material is a bit dry and just used to frame the issues - the interesting part was the debate and discussion it stimulated.

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