The proper tax treatment of bitcoin gains is generally uncertain. The issue comes down to whether cryptocurrencies are capital assets, foreign currency, or something else. There are strong arguments both for and against any of these treatments, so it’s impossible to give a definite answer. As a tax attorney, I can analyze the interpret the tax law in order to reach an answer that is probably correct, but until the IRS issues official guidance, nothing is for certain.
What treatment is probably correct?
If you invest in bitcoins, it is probably correct to treat cryptocurrencies as a capital asset. This is the safest answer because by definition all things are “capital assets” unless specifically excluded by statute. This means that as long as bitcoins aren’t included in the list of excluded assets under section 1221, then it’s reasonable to treat them as a capital asset. Looking at the statute, you’ll see that bitcoins are not named, nor do they fall within any of the asset categories. There are some narrow exceptions that could apply here, particularly if you are a bitcoin miner, but generally speaking its safe to assume that bitcoins are a capital asset.
As a capital asset, gains and losses on bitcoin transactions are reported in a manner similar to shares of stock or other financial assets. That is, you would calculate your net gain or loss for the year and report that figure using Schedule D of your income tax return. The tax rate will depend on whether your net gain is short-term or long-term. Long-term capital gains arise from assets held for more than one year and are given a lower tax rate than short-term capital gains. If you have a “net loss” instead of gain, you’ll be allowed to deduct up to $3,000 of that loss on your income tax return. The rest of the loss (if any) must be carried forward to future years.
What treatment is possibly correct?
It is possibly correct to treat bitcoin as a foreign currency. The trouble in doing this is that no legal precedent exists for treating a non-minted asset as currency. This means that any attempt to categorize bitcoin a currency is merely speculation until official guidance is provided by the IRS. Until that time, anyone electing to treat bitcoin as a foreign currency runs the risk of having their tax treatment rejected if the IRS subsequently determines that bitcoin is not a foreign currency.
Assuming that this does not occur, the tax treatment of bitcoin as a foreign currency would be determined under section 988 of the Internal Revenue Code. Under this section, all gains and losses from bitcoin would be characterized as ordinary. This means that gains are taxed at the normal income tax rates (i.e. the same as your paycheck) and that losses are fully deductible (not subject to the $3,000 limitation). Therefore, investors would lose the benefit of the long-term capital gains rate, while gaining the benefit of fully deductible losses.
Perhaps the largest benefit to taxing bitcoin as a foreign currency is the exception for “personal transactions” under Section 988(e). Under this exception, gains of less than $200 are tax free as long as the transaction is not for investment or business purposes. Assuming that most consumer transactions generate less than $200 of gain, there would be no tax consequences to the use of bitcoin for personal spending. The implications of this outcome are significant.
If the gains on personal transactions are greater than $200, they are no longer tax-free. However, instead of taxing them as ordinary income, the code taxes them as capital gains. Thus, the gains would be eligible for the lower tax rate given to long-term capital gains. Although not as significant as the $200 exemption mentioned above, this still offers significant tax savings for those use bitcoin for day-to-day personal transactions.
So treatment should I use?
This is a decision for you to make after consulting with a tax attorney on your specific situation. Each has its own benefits and drawbacks that need to be carefully considered. In the end, nothing is for certain until the IRS provides guidance on the issue.