China recently banned initial coin offerings. Jamie Dimon has called Bitcoin a fraud that may get someone killed. Russia has changed position from last year’s opposition to cryptocurrencies to now planning to introduce a regulatory framework by the end of 2017. Central banks are somewhat troubled by cryptocurrencies because they represent a loss of control.
The United States was relatively early to the conversation about cryptocurrencies, by developing a theory and practice of how to tax them.
Since this notice was issued, there have been a number of helpful articles on the subject.
A Binary Choice
The primary choice that IRS was faced with was whether to tax cryptocurrencies as property or currency. The layman’s approach might favour currency treatment: it matches the name. The IRS took another path, relying on the fact that – whilst it is a currency in name and has certain characteristics of a currency (such as medium of exchange, unit of account, store of value) – cryptocurrencies are not accepted as legal tender in any jurisdiction. In this respect, the IRS defers to central bank authority, in effect saying that the overriding characteristic defining a currency is the imprimatur of a government or monetary authority.
The IRS has decided to treat cryptocurrencies as property. In doing so, it invokes a taxation regime that taxpayers associate with physical and financial assets such as real property, personal property, stocks and bonds. This characterization is important for several reasons and some of those create some problems because cryptocurrencies are being used both as property and as currencies by the investor and user community.
Investors treat cryptocurrencies in a comparable way to how they treat many financial assets. They buy and sell for profit and sometimes make losses. The determination of profit or loss is dependent on the tax basis on acquisition versus the sale price. For most investors – banks being an exception – the gain or loss is capital in nature. If the gain is realized after a holding period greater than twelve months, the gain is considered long-term and taxed at a lower rate. Capital losses are limited in their ability to be offset against ordinary income to an amount of $3,000 per annum. Capital losses can offset capital gains in an amount limited simply to the amount of those gains.
It is relatively complicated to keep track of this basis for cryptocurrencies. Their value must be translated into US dollars at the time of purchase and sale. Where stocks and bonds are concerned, systems exist to make tracking the acquisition price of a block of stock or a particular bond easy. Such record-keeping is not as common with cryptocurrencies. All bitcoins look the same unless held in separate “wallets”. Recordkeeping will, therefore, need to improve.
If the IRS had decided to treat cryptocurrencies as foreign currencies, taxation would have been different because, by default, gains and losses would have been taxed at ordinary rates. While these rates are the same as capital taxation for transactions under twelve months, there is no long-term, more favourable rate for ordinary income. The key difference concerns losses: ordinary losses are unlimited in their ability to be offset against equivalent amounts or ordinary income. There is also the option for taxpayers to designate foreign currency transactions such that profit and loss can be characterized as 60% long-term and 40% short term. Active traders would probably have preferred cryptocurrencies to have been taxed as foreign currencies.
Users are distinct from investors; their primary interest in cryptocurrencies is using it as a medium of exchange or payment. While users may consider the utilization of a cryptocurrency as being analogous to a dollar bill, the reality in terms of tax is more complex.
The IRS requires taxpayers to keep track of a unit of cryptocurrency in the same manner as if it were being bought, held and sold as a financial asset. If two taxpayers were to enter into a barter transaction for widgets using Bitcoin as the medium of exchange, the purchaser providing Bitcoin must calculate the value of it at the time of purchase versus their cost basis in the Bitcoin. The seller must measure its cost basis in the widgets, versus the market value of Bitcoin at the time of sale and also keep a record of that market value for the purpose of future transactions.
There are similar problems relating to payment for services in cryptocurrencies that have implications for employment-related taxes. Such treatment is cumbersome.
One of the more useful parts of the tax code is IRC Section 1031, which governs the tax treatment of like-kind exchange property. If a real estate investor (the provision is not limited to real estate) has a built-in gain on a piece of property it wishes to sell, it may defer realization of taxable gain on that property by selling it and replacing it with a property of like-kind within a prescribed period of time. A vibrant industry has developed in assisting taxpayers to find such properties. It is not clear whether Section 1031 applies to cryptocurrencies.
The fact that the IRS has issued some guidance on the taxation of cryptocurrencies suggests that they are evolving into the mainstream of the capital markets. This guidance will improve, and the promise of blockchain being transparent in its pricing and record keeping should be easily achieved if market participants want extensive acceptability.