Tracker Series

How the Bitcoin Tax Will Impact Transactions

By David S. Evans

Only the bitcoin community could put on a happy face when the IRS led the way for tax authorities around the world to blow up billions of dollars of value for bitcoin holders.

Coindesk, in its typical only-good-things-happen-in-bitcoin-land, noted cheerfully that, “The increased clarity … will come as a relief to many who were scared to get involved in bitcoin, commercially.” They add that its good news because it could have been worse:  the IRS could have treated bitcoin as a foreign currency which has even worse tax consequences than treating bitcoin as a commodity.

If the bitcoin media were running the nightly news the pretty anchorwoman would chirp: “A massive fire destroyed a building today. But no big deal, it could have been the whole block. And the building was ugly anyway so it turned out to be for the best.”

So how bad will the IRS ruling, and what are likely to be similar rulings elsewhere, going to be for the currency ambitions of the bitcoin community?  I think it just about kills any chance the bitcoin will enter mainstream use.

To remind you, the IRS said that bitcoin was property to which general tax principles apply.  If you’ve bought bitcoins, and they’ve appreciated, you are supposed to pay capital gains when you exchange them to pay for something or for currency. If you’ve held them a year of less you are supposed to pay short-term capital gains (10-39.6 percent federal); if you’ve held them for more than a year you are supposed to pay long-term capital gains (0-20 percent federal).  So if you bought bitcoins for $800 and bought something for $1000 you’d pay taxes of up to $80 if you held them for less than a year and up to $40 if held them for more than a year. (I think I’ve forgotten a few surtaxes here, so it is probably worse, and then there are state taxes.)

If you’ve had capital losses you may get a tax benefit. But roughly speaking this is asymmetric. You have to pay capital gains tax. You may get the benefit of taking capital loss deductions if you can offset other capital gains or in some other circumstances.

All this comes with paperwork requirements.  I’m far from an expert on this (in fact I have a physical aversion to paper) but I think it means that exchanges will need to keep track of purchases and sales and and send K-1s to wallet holders. Those tax forms go to the IRS and that means that it will be hard for bitcoin users to ignore them.  And of course the exchanges will need to pass the cost of the paperwork requirements on to their wallet holders or merchants.

All of this is run of the mill for investors who are buying and selling stocks, bonds, commodities, and various derivatives.  So other than the fact that people will have to follow the tax laws they follow for any other investment there’s no news here.  You can trade bitcoins just like porkbellies all to your heart’s content. Ye haw!

But the IRS tax ruling wreaks havoc on the use of bitcoin as a currency.  Every purchase requires the buyer to make a calculation of short-term versus long-term capital gains, or capital losses.  That’s different from every normal payment instrument. If my “currency” has appreciated I have to think about holding longer until I I’m incurring lower long-term capital gains and then I need to think about whether the currency is going to appreciate or depreciate over time.  If my “currency” has depreciated I have some incentives to exchange to get my tax write off so long as I don’t think it will appreciate and I can benefit from the capital loss.  Boy, this is complicated.  All I want to do is buy the damn sofa on Overstock.com.

Early adopters of bitcoin may not care so much.  Some of them may just love using bitcoin no matter whether it is makes financial sense or not. But mainstream users aren’t going to adopt a currency that imposes paperwork and tax requirements.  Consider someone who is only interested in having a convenient way of paying for things. They replenish their wallets periodically with bitcoins.  On average they are going to pay short-term capital gains taxes. The price goes up and down. They own taxes on the capital gains upside and don’t make it back on the downside on average.

The IRS tax ruling magnifies the fundamental problem of bitcoin as a currency.  Stability is to a currency what picture quality is to TV.  There’s a reason why global markets like the stable dollar and why people in countries with unstable currencies try to use dollars or some other stable currencies.  Stable currencies grow in use, unstable ones don’t.

Bitcoin has been a highly unstable currency. I did some calculations for the month of January 2014 which wasn’t a bad month for bitcoin. Bitcoin was 20 times more unstable than the Euro, six times more unstable than the Nigerian naira, and 3 times more unstable than the Ukranian hyrvna. Those figures would have been much larger if I had taken a longer time period.

If the fluctuation were around a stable level people would lose more in taxes from the upside than they would be able to take losses on the downside (since again not all losses are deductible). And they would have the paperwork to boot.

A currency that is unstable, with a tax liability, and paperwork has no chance of going mainstream.  Hey we could rename them buttcoins since the IRS will make using them a real pain in the, well, you get the point.

As the bit-coin media might say, that’s absolutely fantastic, because, you know, we really never meant it was a currency anyway and its really a protocol and bigger than the Internet! Don’t worry, be happy. J

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