By Jason Van Steenwyk
The Internal Revenue Service has moved to deflate hopes of bitcoin catching on as a true alternative currency in everyday use for small transactions. In a recent revenue ruling, the IRS declared that bitcoin would be treated as property for federal taxation purposes. As such, holders of bitcoin must realize a capital gain (or loss) every time they present bitcoin in payment for a bagel and a schmear.
This is a problem for those who were planning on using bitcoin as walking around money. Merchants would have to report bitcoin sales and track them by customer, while the customer would have to keep track of the cost of purchase (tax basis) of every bitcoin in his or her wallet.
This makes bitcoin fundamentally different than a currency as we know it: If you stuff your wallet with dollars, you don’t have to declare a capital gain or loss every time you buy a bottle of Diet Dr. Pepper and a Kit Kat at your local convenience store. You just pay your money and you go on your way.
Under the new IRS rules, however, any third-party settlement providers who contract with a “substantial number of merchants for the purpose of settling payments (think firms like merchant services and credit card processing providers) must issue a Form 1099-K, Payment Card and Third-Party Network Transactions informational return to the IRS and to the merchant.
The IRS ruling puts bitcoin at a decisive disadvantage as an everyday currency for U.S. taxpayers. Yes, those who bought bitcoin at its peak and regret it now would love to spend the bitcoin and realize a capital loss. But they can do that anyway just by selling bitcoin on the open market. Meanwhile, demand could well be crimped by the lack of a prospect of businesses up and down Main Street signing on for all the headaches of accepting bitcoin for small, everyday transactions.
The current maximum capital gains rate for wealthier taxpayers is 23.8 percent. That goes for singles making over $406,750, or married couples filing jointly making $457,600 or more. That’s 20 percent in capital gains taxes, plus an additional 3.8 percent surtax imposed by the affordable care act.
That gain is calculated by the amount you receive for the bitcoin when you spend or sell it (the IRS doesn’t care whether you sell it or trade it for goods and services) minus the basis, or the fair market value of the bitcoin the day you acquired or received it.
Bitcoin versus currencies
If the IRS had elected to tax bitcoin the same way it taxes currencies, it would have allocated 60 percent of profits to capital gains, and 40 percent in ordinary gains.
This is important for people who have losses, because ordinary gains can be applied to offset any form of income. Investors aren’t restricted to writing off only $3,000 in ordinary income taxes per year and carrying the rest over. (note – if you qualify as a trader – see my last column – you can write off more.)
The crucial difference, however, is this: Had the IRS ruled that bitcoin is a currency rather than property, personal bitcoin transactions would not be a taxable event, according to Tyson Cross, a CPA and owner of Bitcoin Tax Solutions.
Do you ‘mine’ bitcoin? That’s income. The IRS will assess ordinary income taxes on bitcoin you acquire as a result of the digital mining process. You have to declare the income based on the amount the bitcoin was worth when it was awarded on the blockchain to you. What? You thought it was going to be free money? Not once the IRS gets through with you!
That’s just the beginning, though. The value you receive gets counted as ordinary income right away. But if the bitcoin grows in value, you’ll get hit with capital gains income liability again, when you sell it or spend it.
It gets worse. You’ll also have to pay self-employment taxes on mining activities, adds Cross. Mining doesn’t count as investment income, and so is subject to OASDI and Hospital insurance (FICA) taxes. So figure another tax burden of 15.3 percent of net income from mining right there.
But you can deduct the cost of the electricity you use. So there’s that.
For longer-term investors, the IRS doesn’t matter much, if viewed from a pure taxation perspective. The damage comes from in any decline in demand for bitcoin, and therefore reduction in price, as a result of the decreased utility of bitcoin for everyday currency-like transactions.
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