The bitcoin logo (Photo credit: Wikipedia)
Buttressed by an Internet craze, the price of bitcoin has skyrocketed this past year from $17 to over $1,200. Pundits expect significant price volatility in 2014 as well.
While the Federal Reserve gave tacit approval, stating “virtual currencies like bitcoin have legitimate uses and should not be banned,” the IRS has not yet issued tax guidance. Despite the lack of guidance, income from bitcoin transactions must be reported.
What’s the bitcoin tax treatment for traders?
There are two possibilities how bitcoin should be treated for tax purposes: either it is an (1) intangible asset, or (2) a foreign currency. The problem with saying that it’s a currency is that it is not issued by a government, and traditionally currencies are legal tender issued by governments. In California Bankers Assn v. Shultz, the Supreme Court stated (in a non-tax context): “‘Currency’ is defined in the Secretary’s regulations as the “coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.”
The IRS has not said its opinion, but both Canadian and Swedish tax authorities are treating bitcoins as an asset. Also, the German Finance Ministry says bitcoin is not classified as e-money or a foreign currency, but is rather a financial instrument under German banking rules. It is our sense that unless Congress enacts legislation to treat bitcoins as a foreign currency, the IRS will treat bitcoins as an asset.
If you buy bitcoin for purposes of appreciation and then sell it, then if (1) bitcoin is an asset, you will have capital gain and loss, and (2) if bitcoin is a foreign currency, then under Section 988 you will have ordinary income and loss.
Is bitcoin a commodity?
There is no definition in the Internal Revenue Code of “commodity.” Black’s Law Dictionary 342 (4th ed. 1968) defines commodity: a movable article of value that can be bought or sold. A bitcoin is not movable property, so arguably it’s not a commodity. But at the Senate hearing, academics and financial industry players warned that bitcoin could be regulated as a commodity if market volatility continues. Such financial regulation may or may not impact the tax treatment.
Most bitcoin investors and traders will prefer capital gains tax treatment
After the astronomical rise in bitcoin this past year, most investors and traders may prefer capital gains and loss tax treatment. Consider this example: An American investor bought bitcoin at $17 just over 12 months ago and he sold it recently for $1,200. Is he entitled to significantly lower long-term capital gains tax rates of up to 20% in the top bracket and up to 15% in the second top bracket? That’s 20% lower than the top ordinary rates of 39.6% and 35%.
In this example of incredible appreciation, investors and traders will prefer that the IRS views their bitcoin transactions as trading in a commodity or other capital asset held for price appreciation. As long as the investor did not acquire the bitcoin as part of his business or for personal reasons this tax treatment seems safe to deploy on 2013 tax returns — until the IRS says otherwise.
Can bitcoin traders use ordinary loss tax treatment in Section 475?
What goes up fast and irrationally may also go down fast and irrationally. New investors may wind up with big trading losses and they may wish for ordinary loss treatment instead of $3,000 capital loss limitations and large capital loss carryovers.
As the bitcoin trading market expands, some bitcoin traders may be able to achieve trader tax status – business treatment – on trading that asset class. It is not clear whether they can make a Section 475 MTM election for trading bitcoin to have business ordinary gain or loss treatment. Section 475 allows “Traders in Securities and or Commodities” to make the election. Although the term “commodities” above really refers to trading Section 1256 contracts or regulated futures contracts, Section 475 does not seem to include bitcoin. However, if bitcoin becomes regulated as a commodity, it may qualify for Section 475 treatment.
Mark Feldman contributed to this article.