The news that bitcoin is to be treated as property by the IRS has sparked fear among fans of the cryptocurrency. But many of the concerns are overblown.
America’s Internal Revenue Service ruled on Tuesday that bitcoin should be treated more like stock than cash. On the one hand, that means that people who buy bitcoin and then sell it at a profit are potentially liable for lower taxes than they would otherwise be.
On the other hand, it renders bitcoins significantly more difficult to use as a currency. Spending bitcoin on a product counts as cashing out, and so there would potentially be a capital gain to record in the user’s accounts. In the simplest terms, if a bitcoin bought for $5 appreciates in value enough to be used to buy a $1,000 PC from Overstock.com, the customer would have to declare and pay tax on a $995 profit.
That’s concerning, but not the end of the world for bitcoin’s hopes as a currency. But some fear that this ruling is even more damaging than it first seems.
Adam Levitin is a law professor at Georgetown University, and he believes that the ruling means that bitcoin can never be treated as “fungible” – a term from economics which refers to the fact that particular instances of a good are interchangeable. So, for instance, crude oil is fungible, because if a trader buys a gallon of it, they don’t care which gallon they get. Fine art is not fungible, because which work they get matters a huge amount.
After the ruling, “the price at which a particular Bitcoin was acquired (and this is traceable) determines the capital gains on that particular bitcoin when spent,” Levitin argues. “If I spend bitcoin A, which I bought at $10, but is now worth $400, I’ve got a very different tax treatment than if I spend bitcoin B, which I bought at $390.
“This means Bitcoins are not fungible, and that makes it unworkable as a currency. If I have to figure out which particular Bitcoin in my wallet I want to spend and what the tax treatment will be, Bitcoin just doesn’t work as a commercial medium of exchange.”
But in the absence of further advice from the IRS, some called foul on Levitin’s claim. Even stocks and bonds, the archetypal financial property, are allowed to be accounted for on an “average cost” basis, which involves paying tax on the profit made from the average purchase price of the financial instrument. Such a measure, if applied to bitcoin, would restore fungibility to the currency.
However bitcoin is unique in that, even if average cost accounting weren’t allowed, it could be technologically forced. Similar to the way “tumblers” allow users to spend bitcoins without being traced, by mixing hundreds of bitcoins together in the same wallet before passing them on to merchants, it is trivial to exchange one bitcoin for another.
A user with two bitcoins, bought for $5 and $10, could simply hand them both over to pay for a good worth one bitcoin, and receive one bitcoin as change. That would force both the spent bitcoin and the one received as change to be accounted for at the average cost of $7.50, since it would be impossible to tell which was which.
The treatment of bitcoin as property will still have some irritating effects for those who want to use it as currency, requiring much better record-keeping and raising the prospect of having to include a coffee purchase in your tax return.
But the really interesting problems will come when a similar treatment is applied to criminal law.
In many legal systems, receipt of stolen property is treated very differently to receipt of stolen money. If a pawn shop accepts a stolen bike, its operators are expected to return it to its rightful owner if discovered, without reward. If a coffee shop takes a stolen fiver, it can keep it.
Until someone brings a case to court, it’s impossible to say definitively which version would happen with bitcoin. But the IRS ruling suggests that, in America at least, it could be the former.
In other words, if you think the hassle of having to file taxes on your bitcoin is bad, just wait til the shop you’re spending them in has to check to make sure they aren’t stolen before you can make a purchase at all.