While many last week were scrambling to file their 2013 tax returns, there is another tax storm brewing in the horizon. Virtual currency, particularly Bitcoin, is gaining in popularity and growing more common. But what is virtual currency and what does it mean for taxpayers?
Virtual currency is a form of decentralized online currency that is not backed by any government body, the most popular of which is Bitcoin. Owners “mine” or purchase their Bitcoin, which is stored in a computer file known as a “digital wallet.” Although the value of Bitcoin is high, it is a volatile currency whose value is constantly in flux, making it risky for businesses that accept Bitcoin. On the other hand, one of the Bitcoin’s biggest draws is its anonymity: All transactions are recorded using the parties’ account numbers without names being disclosed.
What many once dismissed as a passing fad has turned into a real market force. Several online retailers such as Victoria’s Secret, Expedia, and Overstock now accept Bitcoin, and even Paypal allows limited Bitcoin transactions. Recently, even gubernatorial candidates in Texas were accepting campaign contributions in the form of Bitcoin.
In response to the growing popularity of Bitcoin, the IRS issued guidelines for taxpayers in January 2014. The guidelines require taxpayers to report income generated from Bitcoin and other convertible virtual currency (meaning virtual currency that can be exchanged for other forms of currency). These guidelines are riddled with flaws. While the IRS stated that Bitcoin is not “real” currency and only exists as a form of property for tax purposes, its guidelines indicate that what might be used as currency by one taxpayer is a capital asset in the hands of another taxpayer. This makes sense because people trade in Bitcoin and treat it like a capital asset. However, it would be difficult to parse out exactly how much of a taxpayer’s “digital wallet” is composed of Bitcoin used as currency versus Bitcoin held as a capital asset. The existence of the “digital wallet” itself creates a reporting problem. How does the IRS plan to tackle the anonymity of Bitcoin owners?
Another flaw in the guidelines is that it treats the mining process itself as a taxable event. The miner has yet to gain any actual benefit from the Bitcoin at that point and so it seems inherently unfair to tax the miner, particularly in a system that is supposed to only tax one’s income. It is akin to taxing a sculptor upon the completion of his work, regardless of whether or not he generates income from a sale.
While taxing Bitcoin is a good idea—it is completely fair for those who generate income in the form of Bitcoin to be taxed—it seems like the IRS’s guidelines provide more problems than solutions. In an increasingly digital world, it might be necessary for the IRS to approach the unique concerns of virtual currency in an equally unique manner.