The Taxman Meets Bitcoin

By David S. Evans on March 31, 2014

Only the bitcoin community could put on a happy face when the IRS led the way for tax authorities around the world to blow up billions of dollars of value for bitcoin holders.

Coindesk, with its typical only-good-things-happen-in-bitcoin-land attitude, noted cheerfully, The increased clarity ¦ will come as a relief to many who were scared to get involved in bitcoin, commercially.  The reporter adds that its also good news because it could have been even worse news:  the IRS could have treated bitcoin as a foreign currency which would result in even higher taxes.

In a world where the bitcoin media were running the nightly news, the anchorperson might be chirping: A building burned to the ground, but it could have been the whole block. Also, the building was ugly anyway.

So how bad is the IRS ruling, and what are likely to be similar rulings elsewhere, for the currency ambitions of the bitcoin community?  It kills any chance the bitcoin will enter mainstream use.

To remind you, the IRS said that bitcoins were property to which general tax principles apply.  If you’ve bought bitcoins, and they’ve appreciated, you are supposed to pay capital gains when you exchange them to pay for something or for currency. If you’ve held them a year or less you are supposed to pay short-term capital gains (federal rate of between 10 and 39.6 percent); if you’ve held them for more than a year you are supposed to pay long-term capital gains (federal rate of between 0 and 20 percent).

If you bought bitcoins for $800 and bought something for $1000 you’d pay taxes of up to $80 if you held them for less than a year and $40 if held them for more than a year.

If you’ve had capital losses you may get a tax benefit. But roughly speaking this is asymmetric. You have to pay capital gains tax. You may get the benefit of taking capital loss deductions if you can offset other capital gains or in some other circumstances.

All this comes with paperwork requirements.  I’m far from an expert on this (in fact I have a physical aversion to paper) but I believe it means that exchanges will need to keep track of purchases and sales and and send K-1s to wallet holders. Those tax forms go to the IRS and that means that it will be hard for bitcoin users to ignore them.  And of course the exchanges will need to pass the cost of the paperwork requirements on to their wallet holders or merchants.  Merchants will have paperwork requirements too if they are getting paid in bitcoins, as opposed to using one of the wallet providers that converts consumer bitcoin payments to traditional currency for the merchant.

The IRS tax ruling wreaks havoc on the use of bitcoin as a currency.  Every purchase requires the buyer to make a calculation of short-term versus long-term capital gains, or capital losses.  That’s different from every normal payment instrument. If my currency has appreciated I have to think about holding longer until I I’m incurring lower long-term capital gains and then I need to think about whether the currency is going to appreciate or depreciate over time.  If my currency has depreciated I have some incentives to exchange to get my tax write out off so long as I don’t think it will appreciate and I can benefit from the capital loss.

Boy, this is complicated!  As one VC put it put it, It’s challenging if you have to think about capital gains before you buy a cup of coffee.

Early adopters of bitcoin may not care so much.  Some of them may just love using bitcoin no matter whether it is makes financial sense. But mainstream users aren’t going to adopt a currency that imposes paperwork and tax requirements.  Consider someone who is only interested in having a convenient way of paying for things. They replenish their wallets periodically with bitcoins.  On average they are going to pay short-term capital gains taxes. The price goes up and down. They owe taxes on the capital gains upside and don’t make it back on the downside on average.

As I’ve pointed out in previous post bitcoin has never been a plausible currency because it is designed in way that makes its value unstable.  The IRS ruling makes this problem worse.

Stability is to a currency what picture quality is to TV.  There’s a reason why global markets like the stable dollar and why people in countries with unstable currencies try to use dollars or some other stable currencies.  Stable currencies grow in use, unstable ones don’t.   Bitcoin has been a highly unstable currency.

I did some calculations for the month of January 2014, which was a relatively stable month for bitcoin. Even so, bitcoin was 20 times more unstable than the Euro, six times more unstable than the Nigerian naira, and 3 times more unstable than the Ukranian hyrvna. Those figures would be much larger if taken over a longer time period.

Now let’s factor in taxes. If the fluctuation were around a stable level people would lose more in taxes from the upside than they would be able to take losses on the downside (since again not all losses are deductible). And they would have the paperwork to boot.

A currency that is unstable, with a tax liability, and paperwork has no chance of going mainstream.  As the bit-coin media might say, that’s absolutely fantastic, because, you know, we really never meant it was a currency anyway and its really a protocol and the bigger than the Internet! Be happy.

About the Author

David S. Evans
Chairman, Boston
(617) 320-8933
Antitrust/Competition Policy; Labor and Discrimination; Financial Regulation