Friday, January 17, 2014

The IRS Isn't Sure How Bitcoin Will Be Taxed

As the sudden demise of Coinye West showed, death still applies to the world of cryptocurrencies—but do taxes?

Yes, eventually Bitcoin may be mainstream enough that citizens will need to report their earnings and transactions to the feds. Whether or not they actually do is another question, as Bitcoin was designed to subvert the existing financial system. But how would taxing it even work, assuming holders would cop to making purchases or trades with it?

The tax rules for online currencies, originally drafted for virtual worlds like "Second Life," are pretty dated, which prompted the IRS's national taxpayer advocate to ask Uncle Sam to clarify them. The key question the IRS needs to address, according to the NTA's 2013 Annual Report to Congress, is whether or not cryptocurrencies such as Bitcoin are in fact currencies in the feds’ eyes, or some other kind of financial instrument, like stocks and gold.

The reason this distinction is important is because currencies and regular income are taxed much more heavily by the IRS than capital gains—which are used primarily for stocks, real estate, and commodities. That’s true at every income level, but especially at the lower end.

For example, someone with a taxable income of $85,000 would end up paying about five percent more tax on that income if Bitcoin is treated as a currency than if it were treated as a capital gain, per the Wall Street Journal's handy chart. On the lower end of the scale, someone with a taxable income under $36,250 doesn’t pay any tax on investment activity, whereas regular income would be taxed between 10 to 15 percent. Even for the rich, it’s still advantageous, as someone earning a taxable income of $399,000 would pay a regular income tax rate of about 35 percent, versus the capital gain tax of 15 percent.

If being assessed a lower tax rate wasn’t enough of an advantage already, treating Bitcoin and its ilk as capital gain income would also allow cryptocurrency traders to use a range of creative accounting techniques to offset gains, which lowers the total amount of tax owed, and they could even potentially dodge some taxes altogether.

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