Bitcoin Gets a Visit From the Tax Man

Cameron Winklevoss, left, and his twin brother Tyler leave a federal appeals court in San Francisco, California, U.S., on Tuesday, Jan. 11, 2011. Facebook Inc.'s settlement of claims that its founder Mark Zuckerberg stole the idea for what became the world's largest social-networking website should be undone, former college classmates of Zuckerberg told an appeals court. Photographer: Noah Berger/Bloomberg via Getty Images *** Local Caption *** Cameron Winklevoss; Tyler Winklevoss
Time for a chat with the account. Photo: Bloomberg/2011 Bloomberg

The IRS just made Bitcoin's path to the mainstream even bumpier.

In a ruling issued yesterday, the agency announced that Bitcoin would be treated as property for tax purposes, rather than as a currency. That's bad news for Bitcoin believers, who may be watching their dreams of a frictionless global payments system go up in smoke.

Here's what I mean: If I visit a business that accepts Bitcoin – say, Murphy's Taproom in Manchester, New Hampshire – and I buy a pint of Guinness, I might spend about $5, or about .01 Bitcoin. If Bitcoin is a currency, that's the extent of the transaction –  the store's Bitcoin wallet gets a transfer of .01 BTC from my Bitcoin wallet, and I get my beer. (The government could, down the road, decide to apply a sales tax to Bitcoin-denominated transactions, but they haven't yet.) I don't have to keep any special record of the sale or record it in any ledger. It's as if I were paying for my beer with euros instead of dollars – Bitcoin is just another foreign currency.

But if Bitcoin is treated as property – as it will be, unless the IRS's decision is reversed or some sort of exemption is carved out later in the rule-writing process – the same transaction becomes much more complicated. I now have to pay capital gains taxes on any price appreciation between the time I bought my fractional Bitcoin and the moment I use it for a purchase. So if I bought my .01 Bitcoin for $2 and used it to buy a $5 pint of Guinness months later, I'm now liable for taxes on the $3 difference. Depending on how much I earn and how long I've held onto my Bitcoin, I could owe as much as a 43 percent tax on that $3 on April 15. Suddenly, my $5 beer costs more like $6.25.

You can see how the IRS's ruling could cripple Bitcoin's use as a global payments system. The sheer amount of paperwork and expense involved in conducting Bitcoin-denominated transactions will make it prohibitive for most U.S. consumers and retailers. (This is especially true when it comes to Bitcoin micropayments, a long-held dream of the Bitcoin faithful – just imagine recording capital gains on 100 transactions a day.) Even if services get built that automate some of the legwork involved in transacting in Bitcoin, it will hardly be the "friction-free" payments system many in the crypto-currency community have been rhapsodizing about.

Today's announcement wasn't a complete surprise – Bitcoin diehards have been preparing for it, as have some perceptive tax attorneys. But it's still not welcome news. As the website BitcoinTaxes puts in its FAQ: "Can you imagine having to report everything you ever buy in a year with cash on your tax forms? It'd be unworkable."

If there's a silver lining for the Bitcoiners, it's that the capital gains treatment goes both ways – capital losses in Bitcoin can be deducted from income for tax purposes. If Bitcoin prices plunge, in other words, the Winklevii could have some good news for their accountant.