Taxing Digital Property - Issues and Solutions for How the IRS is Dealing With Bitcoin
The way governments regulate and tax cryptocurrencies will be one of the top influences in shaping the role of Bitcoin in society. In the next few years scaling solutions will hopefully be operational and crypto will have wide spread adoption so that users can spend Bitcoin for everyday purchases. However, currently Bitcoin is classified as property for tax purposes and that could hold Bitcoin back. As blockchain use becomes more common, something needs to change when it comes to US taxes.
Many Bitcoin early adopters were attracted to the anti-establishment potential of Bitcoin and are opposed to paying any taxes on it. However, the IRS is getting more serious about collecting taxes on Bitcoin and the only way to really spend Bitcoin wealth at this point in time is to convert it back to fiat. This leaves many people trying to figure out the tax code.
The IRS needs to look in the mirror before complaining that people aren't paying crypto taxes. Bitcoin is defined as "property" so every time it is exchanged for something else, this triggers a tax event. The user is supposed to pay capital gains on any increase in value from when they acquired the Bitcoin to the moment of each sale. Taxing crypto this way only makes sense for buy and hold investing, but blockchain is proving to have a ton of viability outside of just store-of-value.
The current tax rules lead to unrealistic expectations with Bitcoin and tracking gains. The hugely popular Ethereum app CryptoKitties is an even more complicated case. For those who don't know, CryptoKitties is an Ethereum app where users buy, sell, and breed digital cats. Should purchasing a cryptokitty really be an event that triggers capital gains? Does the ability to sell cryptokitties make them a "convertible virtual currency" under the IRS definition? Is breeding them the same as mining, and thus taxable income even if you don't sell them? How should the price of a newly bred cat be fairly evaluated before it is sold? These are all complicated tax questions, and I am not sure the IRS wants to answer them about every application that arises for the blockchain.
CryptoKitties is not that different than traditional video games with in game items and currencies, and maybe video games represent a model for handling other digital property in terms of taxation. The closest thing I could find to an IRS opinion on farming video game wealth and exchanging it for fiat was an NPR Transcript (Online Gaming, Money and Tax Law.) Selling video game skins and items for fiat is a reasonably large market and should be taxed as income, but the IRS doesn't care about people tracking all their in-game transactions as tax events.
The complaints about Bitcoin taxation are not just that the rules are inconvenient; the IRS has provided no rules at all on some major issues. A group of CPAs formally sent a request for clarity on the allowance of Like-Kind exchanges that has gone unanswered. This would allow the transaction of Bitcoin to other similar property (AKA alt-coins) without triggering capital gains, and would be a huge benefit to people trading between Bitcoin and other currencies.
There is also zero guidance on taxation of coins such as Bitcoin Cash that were created from a fork, an issue that will affect taxes this year for literally every holder from pre-August. The IRS is asking citizens to declare owning Bitcoin and guess how to pay taxes on it, with potentially serious penalties if they later decide things were done the wrong way.
To be fair, crypto taxation is a complicated issue. The technology and its adoption are changing at a rate that is hard for policy to keep up with. Despite this, it is insane and inexcusable that the IRS has not provided updates to taxing virtual currencies since 2014. This is a specialized tax agency with a budget of $11 Billion per year. They have the manpower to go after Coinbase and pursue bitcoiners for tax evasion. The least they owe the public is a guideline for compliance.
Ideally, the IRS will release new rules on cryptocurrencies that simplify and clarify the process of paying taxes. One way to do this is to treat virtual currency as a hybrid between property and currency. Most people use Bitcoin purely as an investment instrument similar to stocks or gold, so it does not make sense to use the tax laws regarding foreign currencies. However, treating Bitcoin the same as an investment like stocks is flawed when considering its functionality as a payment system.
A new, hybrid classification could allow an entirely new set of custom rules. Transacting with crypto for other digital property should not trigger a tax event. Creating new coins through forks or mining should not trigger a tax event. But exchanging it to fiat or physical goods (above a certain price) should trigger a capital gains tax event and users would need to provide a reasonable cost basis. Sales taxes would be the responsibility of the vendor and priced into goods bought with Bitcoin. Creation of new coins through forks or mining would have a cost basis of zero when converted to fiat.
I am curious what everyone else sees as the way forward on taxation of digital property, please share any thoughts in the comments. The federal government is (unfortunately) clearly not ignoring Bitcoin, but the IRS has released zero guidance on the topics of Like-Kind exchanges and how to deal with forks. It's time for a new set of rules.