Though still largely unfamiliar to the general public, the cryptocurrency known as “bitcoin” has received more and more attention in the last several years. This is due in part to its impressive rise in market value — as of today, bitcoin’s market value fluctuates in the low $4,300 range, but only a few years ago it was exchanged for just a fraction of that amount. Its increase in popularity also stems from its habit of drawing attention from governments across the globe: a number of countries have banned its usage, and other countries seem to be on the verge of banning it in the near future. One big issue surrounding bitcoin has to do with its taxation: given that bitcoin is a fully “digital” currency, and that it isn’t backed by any specific state or government, how do traditional tax laws apply? In this article we will briefly describe the mechanics of bitcoin and then provide a basic introduction to the issue of how it is taxed. In the future, we will examine the taxation of bitcoin in greater detail.
How Bitcoin Works
As stated, bitcoin is a “digital” currency, which means that it does not have any physical existence. There are no physical bitcoins which are physically traded or exchanged for goods or services. Possessing bitcoin means having the ability to transfer bitcoin from one “digital wallet” to another. Digital wallets can be obtained fairly easily and are designed to hold bitcoins just as a physical wallet holds physical currency.
The genius of bitcoin lies in its security as a medium of exchange. When people transact using bitcoin, their transactions are verified by parties who are outside of the transaction, and the verification process depends on complex cryptographic mathematical problem-solving. In other words, in order to verify that a transaction using bitcoin is valid, an outside party has to solve a complex problem. Once a transaction has been verified in this way, the transaction becomes logged in a public record which is viewable to anyone. In this way, bitcoin seeks to be a more transparent medium of exchange which is also more secure than traditional electronic transfer of physical currency.
Taxation of Bitcoin
As mentioned, the market of value of bitcoin has grown exponentially in recent years. Whether its value will rise or fall is uncertain, but what is clear is that many individuals have profited enormously due to bitcoin’s spectacular improvement. And whenever someone profits by any means, we have to expect that the taxman will soon be there to receive his cut. Thus far, the IRS has issued guidelines which have tried to classify bitcoin as “investment property” like other financial instruments such as stocks and bonds. Under this classification, someone who bought bitcoin back when its value was only a fraction of its current market value would simply pay at the familiar capital gains tax rates. And those who “mined” bitcoin — an issue to be covered in the future — would claim the bitcoin as if it were received as employment income instead.
We can commend the IRS for at least attempting to bring clarity to this novel situation; but as soon as we look deeper and consider some of the unique aspects of bitcoin, we can see that this straightforward application of preexisting tax laws becomes quite problematic. For instance, it’s all well and good to view bitcoin as investment property — after all, its value has skyrocketed lately — but remember, its primary function is as currency, and so bitcoin users regularly spend their bitcoin to acquire things just as they would spend ordinary physical currency. How will the cost basis of bitcoin be affected when bitcoin is spent as currency? Stock is regularly received as compensation, but it cannot be spent freely like currency. When we retroactively apply pre-established tax laws to bitcoin, we can see easily that the situation is very much like attempting to push a square peg into a round hole.
There are myriad other issues which add complexity to the taxation of bitcoin. In the future, we will dive into these issues in more detail. Stay tuned!
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