Bitcoin Gets a Visit From the Tax Man

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.