Provides legitimacy and clarity for bitcoin purchasers but will complicate taxable gains and losses.
The Internal Revenue Service's decision to treat virtual currencies as property is a mixed blessing for bitcoin.
"On one hand, it provides legitimacy and clarity for bitcoin purchasers. On the other hand, it makes it more messy for individuals to use it in transactions," says James Angel, a visiting professor of finance at the University of Pennsylvania Wharton School.
Because the IRS announced it considers bitcoin property, not a currency, most people who buy and sell bitcoin will face the same taxes they would if they were trading stocks. Those who use it to make purchases could realize a taxable gain or loss on every transaction.
Bitcoin Investors Enthusiastic; the Public, Not So Much
According to a survey by market research firm Harris Interactive, just more than one-tenth of the adults in the U.S. who know about bitcoin say they would choose to invest in it. And the more people know about bitcoin, the less they trust it, according to the December survey of 2,000 adults. People in the Western U.S. knew the most, and yet were more wary of bitcoin than any other region — just 7 percent would invest in it over gold, compared to 13 percent across all respondents.
But at CoinSummit, a two-day conference to discuss bitcoin and its future, enthusiasm for the digital currency was everywhere.
“It’s as bulletproof as anything I have ever seen,” said Marc Andreessen, founder of venture capital firm Andreessen Horowitz.
The firm has invested about $50 million into bitcoin-related projects, and is eager to invest millions more to build a robust bitcoin portfolio, Andreessen said Tuesday. The firm was a lead investor into San Francisco’s Coinbase, a digital wallet to store bitcoins in the cloud.
Bitcoin is a virtual currency and payments network that was created in 2009 by a mathematical formula. The total amount of bitcoins that can be created is capped at 21 million, and bitcoin can be bought on global Internet exchanges. No company, government or organization controls the currency, and no traditional banks are involved in any transactions. On Tuesday, the Internal Revenue Service announced it would tax bitcoin as property and not recognize it as legal currency.
Last month, the world’s largest bitcoin exchange, Japan-based Mt. Gox, filed for bankruptcy after saying it had lost more than 750,000 bitcoins — and then found 200,000 of them in a forgotten wallet. And Vircurex, an exchange and trading platform, announced Monday it would halt operations after hacking incidents last year depleted users’ accounts, and Vircurex was left to cover the loses.
Supporters say the bitcoin community is learning from the mistakes of Mt. Gox, and compare the recent bitcoin scandals to the early days of the Internet, when AOL and Hotmail accounts were hacked, and international hacking groups siphoned millions from big banks.
“It forced other players to get better at security,” said David Johnston, co-founder of BitAngels, an angel investors group focused on advancing bitcoin technology.
Supporters are pushing for more ecommerce companies and retailers to accept bitcoin as payments. San Francisco-based Gyft, a digital gift card startup, is now allowing customers to purchase Wal-Mart gift cards using bitcoin. And Patrick Byrne, chief executive of online discount retailer Overstock.com, became an unofficial spokesman for the currency when in January his company became the first large online retailer to accept bitcoin.
"In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability," the IRS said in guidance published Tuesday.
Suppose you buy a bitcoin for $500. Its value rises to $800, and you use it to purchase $800 worth of sheets and blankets on Overstock.com. The difference - $300 - would be a capital gain. If you held the bitcoin for one year or less, it would be taxed as a short-term gain, at the same rate that applies to ordinary income from a job or self-employment. If you held it for more than one year, it would be taxed at the lower long-term capital gains rate.
Overstock.com, which in January became the first major U.S. retailer to accept the crypto-currency, would recognize $800 worth of sales, just as it would if the transaction took place in dollars. A merchant selling its own inventory would not be required to send you or the IRS a Form 1099 reporting the transaction, although it still could be traceable, says Lee Sheppard, a contributing editor with Tax Notes.
If, when you sell your bitcoin or use it to make a purchase, it is worth less than you paid, you would recognize a loss, which can be used to offset gains. When you file your taxes, you net out all capital gains and losses to determine if you have a net long-term or short-term gain or loss.
This process would apply to all bitcoin transactions, no matter how small.
"For people using (bitcoin) as a means to pay for something, it would be a capital asset in those hands," and treated as such, says Mark Luscombe, principal analyst with CCH Tax and Accounting.
For people who are deemed to be traders or dealers in bitcoin, any profits generally would be treated as ordinary income. Likewise, people who create new bitcoins through a process known as mining would pay ordinary income tax on the fair market value of the bitcoin at the time it is received.
Although some were hoping the IRS would deem it a currency, the decision to treat bitcoin as property was not unexpected.
"Anyone who thought it had some special status as currency, the IRS is trying to disabuse them of that notion," Luscombe says. "If you hold dollars and they change in value over the course of time, that appreciation is not taxable," he says. If you hold stock or bitcoin and it appreciates, "that is taxable."
The IRS also made it clear that if an employer pays an employee in bitcoin, it will be treated as wages for employment tax purposes. It will not, however, treat bitcoin as a currency that could generate foreign currency gains or losses.
People who had bitcoin transactions last year should consider the new guidance in preparing their 2013 returns.
The IRS notes that bitcoin users could be subject to penalties if they did not treat bitcoin transactions that took place before Tuesday in accordance with its new guidance. However, "penalty relief may be available to taxpayers" who can prove that their failure to comply with the new rules "is due to reasonable cause."
Sheppard notes, "If you were doing this for tax evasion, you don't get penalty relief."
Angel, the Wharton professor, said the complexity of the new rules could discourage smaller merchants from accepting bitcoin.
"If I am Jim's muffin shop, and I am already up to my eyeballs in accounting fees, I would be thinking I will wait until I see a real good business reason to do this," he says. Today, "most merchants accept it as a novelty statement to attract attention or (want to be perceived) as hipsters or are part of a pro-freedom group."
It's unclear how much companies in bitcoin services will help customers in complying with the new rules.
Coinbase, a San Francisco company that provides digital wallets where users can store their bitcoins, said customers can view their transaction history in bitcoins and dollars. But it declined to discuss the new rules beyond the following statement: "The IRS ruling provides clarity and validation which enables bitcoin to be accessible to the masses. Coinbase is prepared to help consumers and merchants meet the guidelines."
In a blog post, the Bitcoin Foundation said it "appreciates the IRS' hard work in providing much-needed clarity to those transacting in digital currencies. ... However, tax treatment of Bitcoin as a property, and not a currency, may make compliance with tax laws unnecessarily cumbersome and imposes untenable recording and reporting requirements on its users."
It added: "The tax laws currently permit individuals to ignore small gains and losses in foreign currencies. Similar treatment for digital currencies would harmonize the law with the way most people actually use digital currencies. Artificially characterizing this use case as a transaction in property would make one of the most innovative features of this technology hard to use for those who wish to be compliant."
Patrick Byrne, chief executive of Overstock.com, says his company takes in about 200 bitcoins per week from customers, which at the current exchange rate equals about $120,000. Initially, Overstock immediately converted all bitcoin into dollars, but in February it started holding on to 10 percent "because one day we might start paying vendors in bitcoin," he said.
He said the IRS ruling will affect that 10 percent, but the additional accounting won't dissuade him from accepting bitcoins.
And Byrne isn't sure whether the decision will discourage customers from paying with the crypto-currency. Some people bought bitcoin at prices much higher than current rates, meaning for them, "using it at Overstock is a way of realizing a capital loss," he said.
©2014 the San Francisco Chronicle