Crypto-Currency: Do Bankers Dream of Electric Money? Part II

The legal environment for bitcoins, and all crypto-currencies, is rapidly developing. On March 25, 2014, the IRS issued Notice 2014-21 answering questions about the tax treatment of virtual currencies. The Notice clarifies that virtual currencies, like bitcoins, are treated as property for tax purposes. On April 2, the House Committee on Small Business held a hearing to discuss the implications of Bitcoin for small businesses.

Regulation is coming to crypto-currency, quickly. Whether or not you think virtual currencies should be taxed like property, Notice 2014-21 was unsurprising. The IRS applied existing regulations to the bitcoin. It had two choices: Bitcoins are currency or bitcoins are property. As discussed in a prior article, bitcoins are not legal tender in the U.S. Further, according to the IRS, bitcoins don’t qualify as a foreign currency because they are not a fiat currency. Hence, bitcoins are property and any transaction using a bitcoin is a taxable barter transaction.

Trading bitcoins is like horse trading. When you dispose of your horse (bitcoin) you take a gain or loss on that sale depending upon the price you initially paid (your basis) for the horse (bitcoin) as compared to the fair market value of the horse (bitcoin) when you disposed of it. So if you go to a local café that accepts bitcoins and pay for your latte with bitcoins, that transaction may be subject to tax.

Based on existing law, the clarifications in the Notice are unremarkable. In fact, dispositions of foreign currencies are taxed similarly. Taxation of foreign currencies is complicated. A simple example will illustrate the thrust of the issue for bitcoins though. If I invest in 100 euros today at $138 and sell them a week later for $150, I’ll be taxed on my gain of $12. There is a very important exception to this rule—an exception that virtual currencies don’t currently enjoy. Small personal transactions in foreign currencies are exempt from taxation.

What does the personal transaction exemption do? I have 5 Euros in a drawer at home. I got them when I went to Italy 8 years ago. My basis in those euros is about $6.35. They are now worth $6.80. If I go back to Europe this year and spend my euros, I won’t be required to pay tax on the increased value of my euros ($0.45). But, if my euros were bitcoins, I’d owe tax (which would be ok—they’d be worth tens of thousands of dollars).

Right now, taxing bitcoin transactions as a barter transaction has major implications. The bitcoin market is immature and bitcoins experience extreme price fluctuations. So, at present, many transactions may be subject to extreme gains or losses. However, the growing certainty around issues like taxation will create more stability for crypto-currencies. Just last week Tera Group, Inc. announced private swap transactions involving bitcoins. The ability to hedge risks is an important evolution in creating a more stable virtual currency market.

Developments like IRS Notice 2014-21 lay a legal foundation for crypto-currencies. Similar developments are going on all over the world. Treatment is disparate for now. Regardless of what policy might be best for economic growth and stability, increasing certainty of the rules will give informed investors and financial institutions confidence to deal with companies having crypto-currency exposure.

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