Over at Slate, Matt Yglesias mentions that, in addition to the existential questions surrounding bitcoin, there are a handful of practical questions that need to be worked out. Specifically, he wants to know if bitcoin transactions should be taxed and, if so, how they should be taxed.
The answer to the first question is easy: yes, U.S. citizens and residents will be taxable on their bitcoin transactions.
The second is a little harder; the IRS has not yet provided guidance for how it will treat bitcoins for tax purposes. Yglesias quotes Catherine Hollander for the proposition that bitcoins will be taxed either as currency or commodities.
To understand what’s at stake, then, it’s helpful to understand how the U.S. currently taxes currency and commodity transactions.
Whether bitcoins are treated as currencies or commodities, holders will be taxable on their gain[fn1] when they sell the bitcoin for money. But they will also be taxable on their gain when they exchange the bitcoin for other property.
Exchanging property for other property or services is a taxable event. If, for example, you buy a bitcoin for $100 and, some time later, use it to buy a necklace on Overstock for $156.59, you recognize $56.59 of gain on the transaction, and owe taxes on that amount. Similarly, if you use appreciated bitcoins to pay for services, you owe taxes when you pay the bitcoins to the service provider.
For tax purposes, commodities are capital assets.[fn2] If the IRS determines that bitcoins should be taxable as commodities, then, they will be capital assets. As long as you’ve owned your bitcoins for more than a year when you exchange them for money, property, or services, you’ll pay taxes on your gain the preferential long-term capital gain rate (currently either 5%, 15%, or 20%, depending on your marginal tax rate).
Alternatively, the IRS could treat bitcoins as a currency. In the tax world, there are two types of currency: functional and nonfunctional currency. For U.S. individuals, the dollar is always the functional currency; any other currency is nonfunctional.
Bitcoins, then, would be a nonfunctional currency. The tax consequence of nonfunctional currencies? Generally speaking, gains and losses on the disposition of nonfunctional currencies will be treated as ordinary gain or loss, taxable (or deductible) at a taxpayer’s marginal tax rate.
Using bitcoins to purchase goods or services is a counterintuitive taxable event for the purchaser. Although there would be no tax consequences if she had used dollars, by using bitcoins, she will owe taxes on the difference between what she paid for the bitcoins and the value of what she gets in exchange for those bitcoins.
That is entirely uncontroversial. How much tax she will have to pay, though, depends on whether the IRS classifies bitcoins as a currency or as something else. And for that, we’ll have to wait.
[fn1] That is, the difference between the amount the holder paid to acquire the bitcoin and the amount the holder receives in exchange for the bitcoin. Where the holder mines the bitcoin rather than buying it from a third party, the holder’s gain will be the full amount she receives for the bitcoin.
[fn2] Other, that is, than some commodities financial instruments held by commodities dealers. For most bitcoin holders, though, that won’t be a problem.