Bitcoin has been on an amazing run. The market cap of bitcoin recently reached over $70 billion, more than Costco, Tesla or eBay, and rapidly closing in on PayPal. But after China closed down Chinese bitcoin exchanges, the price of the volatile virtual currency went sharply down, only to partially recover soon after to again surpass $4,000.
How will government regulation of cryptocurrency evolve? Several years ago, the IRS weighed into this question when it issued Notice 2014-21, providing guidance on how virtual currency transactions should be taxed.
Virtual Currency is Property
The IRS explained that virtual currency would be taxed as property, not as foreign currency. It was far from obvious the IRS would consider bitcoin to be property. After all, the IRS has argued, (and the Tax Court agreed) that information provided by a whistleblower to the government was not property. And in another recent case, the Tax Court held that a complex financial contract was not property.
When is a contract or intangible right “property” for tax purposes? It’s not always clear. In one case the Tax Court announced a multi-factor test for determining when contract rights constitute property. The test depends on, among other factors, how the contract rights originated, how they were acquired, and whether there are significant investment risks. This test is difficult to apply and has not been widely adopted.
Fortunately, after the Notice, we don’t need to rely on ambiguous multi-factor tests or lengthy case law. But the Notice did not answer many other questions, like whether bitcoin is capital or ordinary. That’s important because gain from the sale or disposition of bitcoin is capital gain only if bitcoin qualifies as a capital asset in the hands of the seller. And if the seller has held the bitcoin for one year or longer, the gain is taxed at the preferential rate for long-term capital gain.
What if you sell virtual currency at a loss? If it is a capital asset, you can only claim a capital loss, which can only be used to offset capital gain (plus $3,000 per year of income). Given the severe restrictions on capital losses, taxpayers prefer their losses to be ordinary, and gains to be capital.
What are Capital Assets?
Capital assets include (among others) assets held for investment. Unless you’re a stock or securities broker, that includes things like stock, securities, mutual funds and other investment assets. If you’re a landlord, it also includes the home you’re renting out (although a home may be ordinary for a developer or flipper).
What are Ordinary Assets?
Ordinary assets include things like inventory and stock in trade (i.e., the goods and services that a business sells day in and day out to its customers), certain kinds of property used in a trade or business, as well as notes and receivables acquired in a trade or business. Is bitcoin close enough to stock in trade, inventory, or an account or note receivable acquired in a trade or business to be an ordinary asset? It depends on the holder of bitcoin.
When is Bitcoin Ordinary vs Capital?
The following discussion describes when virtual currency is capital or ordinary for different categories of holders, starting from the easiest and progressing to the more complex.
1. Investors. Bitcoin is capital for investors. When you buy or sell bitcoin on coinbase or another exchange as an investor, you are acquiring a capital asset. Gain or loss will be capital.
2. Traders. Bitcoin is capital for traders, unless the trader is able to make a special tax election. Traders are individuals who engage in buying and selling securities as a trade or business. They are not dealers because they profit from changes in the market price of securities, rather than charging a commission on sales. They don’t carry securities as inventory or hold themselves out as market-makers. (See this case for a discussion of the difference in a case involving a trader in Treasury bonds trying to claim an ordinary loss.) Traders can only claim an ordinary loss on securities if they make a “mark to market” tax election. But it’s unclear if bitcoin is a “security”. If bitcoin is not a security, traders can’t make the tax election, and virtual currency will be capital assets for them.
3. Dealers. Bitcoin is an ordinary asset for dealers. Virtual currency exchanges like coinbase, Bitstamp, Kraken, Bitfinex and others hold bitcoin and other virtual currency as ordinary assets. If they maintain a reserve to make a market and provide their customers with liquidity, any gain or loss on the sale of bitcoin to their customers on the exchange will be ordinary. For these organizations, bitcoin is essentially inventory or stock in trade.
4. Miners. This is where things get complicated. In FAQs #8 and #9 of the Notice, the IRS explained that if mining constitutes a trade or business (which is likely the case for most if not all miners), miners earn ordinary income as of the date of receipt of the virtual currency. Notably, the miners cannot defer taxation by holding onto the virtual currency and selling later. (But an intriguing question is whether they can control the date of receipt.) Moreover, the ordinary income is subject to self-employment tax. However, what if, after the miners mine bitcoin, they hold onto the bitcoin, and it plummets in price? Will the miners be able to claim an ordinary loss? Unclear. What if, instead, the mined bitcoin increases in value? Will they qualify for capital gain? Also unclear.
5. Businesses and Service Providers. When using virtual currency to pay for goods and services, like buying furniture on Overstock.com, the transaction is treated as if the buyer sold the virtual currency right before the transaction, used the cash to purchase the good or service from the seller, and the seller then used the cash to buy the virtual currency. In other words, it’s a taxable transaction for both the buyer and seller. For the seller, the receipt of the virtual currency results in ordinary income. What if, instead of selling immediately after receipt, the seller holds onto the virtual currency and later sells for gain or loss? This is also a complex question, but it seems likely that any gain or loss on a later sale of the virtual currency by the seller will be capital.
Only time will tell if cryptocurrencies represent a fraud, or instead an answer for individuals living in “monetarily oppressive regimes” with currencies subject to massive devaluation and hyperinflation. But as long as the current trends continue, the unanswered tax questions for cryptocurrencies will continue to gain in importance.