IRS States Bitcoins Are Property

So the IRS has issued a Notice on the virtual currency known as Bitcoin:  It’s not a currency, it’s property. Jolly good, you say, so what? Well, that decision has some major tax implications for the future of what adherents will insist is a virtual currency, or “cryptocurrency”.  That has a number of important tax considerations, but for the uninitiated let’s start with the basics, that is, what the heck is Bitcoin?

For these purposes let’s ignore the IRS and grant Bitcoin respect as a “virtual currency”, that is, a medium of exchange, something intangible asset that people can trade for other goods or services (or, other Bitcoins). It owes its existence to computer programmer Satoshi Nakamoto, who created the algorithms related to Bitcoin in and around 2009.  It has no tangible existence – one cannot carry a Bitcoin in one’s wallet – but rather depends upon two types of technology for its existence:  “peer to peer networking” and “public key encryption”.  If you find the technical stuff boring, skip down to “Bitcoins Are Property” below.

Bitcoin Technology

Peer to peer communication is, put simply, stuff that lots and lots of different people on lots and lots of computers do in a “distributed” or decentralized manner, that is, there is no single computer or person that controls what goes on.  Napster was one of the first and best known peer to peer networks for sharing music.  Millions of different people had songs on their computers.  These people used Napster’s software, which you could download onto your computer for free, to share the files over the internet with anyone else also running Napster.

No one was in charge – you simple stood up to be recognized as a “node” on the Napster network, sort of like establishing your own bus stop along a busy route.  Then you shared what you had in the same way as you might conduct a pot luck dinner at your local church.  The church opens its doors, provides the meeting space (and perhaps one of those big silver coffee makers), and everyone brings their own dishes to share.  There are rules:  clean up after yourself, don’t show up empty handed, but otherwise no one is in charge of the event.  Simple.

Then there’s part two – public key encryption. The deep specifics of this system are beyond the scope of this article (and my comprehension), but in simplest terms PKI is a system by which people can share information securely using a “public” key, an external reference that functions a bit like a PO Box, combined with each user’s “private” key, like the key to that box. You send someone a private letter by referencing their PO Box (which is public), but only the owner can open (or “decrypt”, in the computer world) the letter by using their private key.

These technologies are critical to Bitcoin in that its creators needed a system that allowed them to be traded and exchanged using a decentralized (peer-to-peer) secure (PKI-based) system. When Mr. Nakamoto created his alogrithm he set a finite limit on the number of Bitcoins that will ever exist: 21 million. There are currently around 12 million in circulation, with about 9 million more to be discovered. They are created just as virtually as they are traded: anyone so inclined, and with the computer resources and knowledge to do it, can “mine” Bitcoins by verifying existing Bitcoin transactions. The miners get a commission, in essence, for adding value to the entire virtual monetary world.  So, whether you bought your Bitcoins, received them in exchange for goods or services, or mined them you have created or received something of value.

What is Currency?

In addition to technology what makes up a currency is, put simply, that people think its a currency, or a “medium of exchange”.  If I give you a dollar for a lollipop there’s an immediate understanding that what I am giving you has some intrinsic, quantifiable value (that is, a dollar is worth, surprisingly, $1), that the dollar has an equivalent value in goods or services (lollipops), and that the recipient of my dollar can reuse it to exchange for something else that he might want (say, balloons).  This latter part is important.  Part of what makes a currency a currency is not only what the original two transacting parties think (our agreement to exchange dollar for lollipop), but that everyone else understands that what both of the parties got has some measurable value.  In monetary terms the dollar is therefore not only our “medium of exchange”, but is also recognized as “legal tender” for the transaction.  Who decides what is “legal tender”?  The simple answer is the government, in part because of the United States Constitution and in part under policies that have evolved over the years.   For a fascinating history on what makes money what is it (and who gets to decide that) read up on the exceptional Heritage website.

IRS Rules Bitcoins Are Property

As the use (and trading) of Bitcoins has grown so has the government’s interest in them.  Part of why the IRS would care involves whether someone has “acceded to wealth” when they create, sell or exchange a Bitcoin.  In other words, has someone to the transaction gotten richer by dealing in Bitcoins rather than a “true” currency?  It is a longstanding principle of tax law that such accessions to wealth are “income” which might be taxable to the recipient.  I have acceded to wealth, for example, if someone gives me a dollar (for nothing in return), a share of stock or a piece of real estate

Having looked at the issue the IRS came down to the conclusion that Bitcoins are property, not a “currency”.  In so doing the US government made using Bitcoin as a medium of exchange much more complicated.  This is because, put simply, you, the Bitcoin user, must now keep track of what you paid for your Bitcoin, where it came from, and whether you have tax consequences when you use it to purchase something.  This is a whole host of worries you never have to deal with when you use a “true” currency.

The Tax Consequences of Using Bitcoins

So what exactly do you have to track and bother with?  The answer, in short, is your “basis”.  Basis is just a word.  It means “what is my investment in this thing”.  If  you paid $10 for a share of stock, that is your basis in it (more technically, your “cost basis”).  If that stock appreciates to $15 and you sell it, you have “acceded to wealth” by $5, on which you pay tax.  So, when it comes to Bitcoins, according to the IRS, go forth and buy, sell and exchange it however you like, however, be sure you track your basis and report your gain (or loss) each time you do it.

This is a huge pain, perhaps by design.  Tracking one’s basis in readily exchangeable, intangible things like stock, or now Bitcoins, is extremely complicated.  Stock brokers use highly sophisticated software that tracks stock transactions, accounting for all of the Byzantine and upside down rules that govern these transactions.  Few, if any, Bitcoin users are prepared for this level of reporting.  Figuring out your gain or loss also assumes that you are able to trace exactly which Bitcoin you purchased to use for your cup of coffee.  This is similarly difficult given that Bitcoins are “tumbled” into “blocks”, that is, virtually sliced and diced so that it is unclear which Bitcoin you got, or who created or received it.  This serves to protect Bitcoin users’ privacy, something the government is viewing with increasing hostility.

Philosophically I am disappointed, though hardly surprised, with this decision.  Our entire banking system, really, the entire global economy is in large part based on the dollar as a medium of exchange.  That serves an important purpose in that it lends predictability to how oil, carrots or lollipops are priced.  There are many “data points”, that is, places to compare, contrast and get an idea of what something should cost.  The downside, however, is that it preserves a government’s monopoly on how you do business.  Again, this is desirable in many ways, but has a dark side:  the government, not you, decides what the currency is worth.  The more currency the government prints, the less it can buy or earn in the form of interest.  You, the buyer, might not see that the dollar you had yesterday is not the dollar you have today, but those who are exchanging their oil, carrots and lollipops do.  Words you hear a lot like “purchasing power” and “inflation” can be tricky to grasp, but are very important to how people live.

What Now?

The matter is not entirely settled.  Changing how things work depends on how good the idea is, how strong are the forces against it and who has more patience.  Congress, not the IRS, has the ultimate constitutional authority to determine what is considered a “true” currency, and in time this may be the case.  Further, the IRS may have done recent Bitcoin purchasers a service.  Where you have gains you can also have losses.  Just as you accede to wealth through appreciated Bitcoins, you can claim a loss when you didn’t buy so well.  As a practical matter, the IRS is entirely unprepared to enforce its new position regarding Bitcoins, as it is unlikely that more than a tiny fraction of this bureaucracy understand them.  So, time will tell.

I want to hear from you!  Should Bitcoin be considered “currency”?  Does the confidentiality of Bitcoin transactions outweigh the risk that they could be used for illicit purposes?  Leave a comment, or contact me for a stimulating discussion over a cup of coffee.