How Should Bitcoin and Cryptocurrencies Be Taxed?

The tax treatment of cryptocurrencies has been a persnickety affair. Long gone are the days when bitcoin users mistakenly believed that their experiment in monetary innovation would be free from the grabbing hands of the state. But cryptocurrencies' unique properties and uses posed a dilemma for tax authorities seeking to outline a reasonable path for taxation of technologies like bitcoin. Thankfully, a new bill could rectify many of the early mistakes made with the tax treatment of cryptocurrencies.

The tax problem was not an immediately straightforward one to the policymakers looking to address it in the post-2013 bubble haze. Underscoring just how novel bitcoin was to the federal government, a 2013 Government Accountability Office report recommending that the IRS take action on cryptocurrencies was mostly informed by the tax agency's previous stance on virtual and game world currencies like those in World of Warcraft and Second Life. The concept of a totally distributed, censorship-resistant virtual currency understandably exceeded the boundaries of what policymakers had considered thus far.

Adding to the mystification were the myriad applications of blockchain technology. Cryptocurrencies were simultaneously used by different people as a kind of transaction platform, standard currency, investment vehicle, or even a complex financial instrument. It was difficult for policymakers to review this developing landscape and determine which of the many alternative tax options would be most appropriate for the new technology.

There were two likely candidates for the IRS to pursue. It could have either treated bitcoin as a kind of currency, which means that cryptocurrency users would be taxed just as if they were transacting with a foreign currency like euros or pounds, or it could have treated bitcoin as a kind of property, which means that cryptocurrency users would be taxed as if they were earning capital gains.

There were pros and cons to each possibility. Taxation as a currency would entail an overall higher tax rate for cryptocurrency users, which would be a bummer. On the other hand, cryptocurrency users would enjoy what's called a de minimus exemption for transactions under $1,000. This means that users who transacted in bitcoin to purchase everyday items ranging from coffee to furniture would not be liable for any tax.

Transaction as a property would have the desirable benefit of a lower tax rate. However, it would create a huge headache for large swathes of cryptocurrency users that make many regular small transactions. Capital gains taxes work by calculating the difference in price between the time of purchase and time of sale, and taxing that amount. People who primarily use cryptocurrency as a medium of exchange don't necessarily watch the daily price fluctuations in between the time that they bought bitcoin and exchange it for their daily cup of coffee. They just translate the value in dollars in their minds and go about their day.

Yet if bitcoins were taxed as a property, these casual users would be placed in the same tax category as serious monetary speculators, complete with the burden of tracking and calculating substantial price fluctuations between their transactions. Users would then need to adequately document these price changes, prove they had been purchased and sold for the equivalent value in U.S. dollars on the dates claimed, and pay the subsequent tax on the capital gain for each transaction. (Although, there would be somewhat of a silver lining in event of a huge price decrease in that capital losses could at least be deducted from income come tax season.) Talk about red tape!

Unfortunately, the IRS indeed announced that they would treat cryptocurrencies as a property for tax purposes in 2014. While this verdict was met with a good amount of grumbling from the cryptocurrency community, the decision was largely out of the IRS's hands: By statute, the definition of "currency" is limited to the "coin and currency of the United States, or of another country." Stateless cryptocurrencies, by definition, are therefore ineligible for tax treatment as a foreign currency.

(One slight caveat here is for people who receive cryptocurrency as income, either for goods or services rendered or as a "miner" earning newly-minted coins as revenue for their processing power. In these cases, cryptocurrency would be taxed as normal income, calculated by the fair market value of the cryptocurrency upon date of receipt.)

Cryptocurrency services did their best to accommodate users in dealing with the U.S. tax requirements. The popular bitcoin exchange Coinbase, for example, offers a service to customers to automatically calculate and estimate annual tax liabilities based on price fluctuations. But these services will only cover customers if they stay entirely within the exchange ecosystem. In other words, if a customer moved their bitcoins from Coinbase to an Electrum wallet, the user would be on their own to manually calculate their tax burden. What's more, they would have to carefully document all of their transactions, so that they could prove to the IRS that their information is valid.

This situation is clearly unsustainable. It requires well-meaning yet understandably overwhelmed cryptocurrency users to comply with a massive reporting burden. It is not hard to see how one could honestly make mistakes reporting their cryptocurrency tax obligations, leading to potential punishment and fines. Nor was the IRS quick to build the infrastructure to help people navigate this confusing new area of tax policy: In November of 2016, the agency's own inspector general criticized the IRS for lacking compliance initiatives and other tools to help cryptocurrency users. Furthermore, enforcing such requirements could create huge problems for privacy and civil liberties. Already, the IRS has set its sights on Coinbase, requesting that the exchange turn over millions of innocent customers' records so that the tax authorities can paw through for suspected tax cheats.

As Jerry Brito and I noted in our manuscript, Bitcoin: A Primer for Policymakers, there is a better way forward. Ideally, policymakers could combine the low tax rates of a capital gains tax with a de minimus exemption for transactions under some nominal amount. Given the statutory constraints imposed on the IRS, this change would likely take the form of some kind of congressional action.

A new proposed bill that seeks to fix some of the shortcomings of the initial tax treatment for cryptocurrencies looks to be a promising new start. Called the Cryptocurrency Tax Fairness Act, the bill was introduced by the chairs of the Congressional Blockchain Caucus, Rep. Jared Polis (D-Colorado) and Rep. David Schweikert (R-Arizona), with input from Brito and the good folks at Coin Center. If passed, the bill would essentially integrate our recommendations into law.

First, it would establish a de minimus tax exemption for all cryptocurrency transactions under $600. This would allow everyday users of cryptocurrency to enjoy financial freedom without having the extreme burden of tracking and documenting all of their minor transactions. (As an added bonus, such a move might slow down the IRS's overreach into extracting the records of innocent cryptocurrency users from major exchanges.)

Of course, there are still many people who could make enough purchases over $600 to still have a reporting headache. The second major thing the bill would accomplish is to direct the IRS to issue specific guidelines on how users should report transactions to the IRS—the same oversight that it's IG pointed out last year. Such clear guidance would go a long way to re-establishing trust and ease for cryptocurrency users, and it would make the IRS's job a heck of a lot easier to boot!

There are a lot of good ideas in this legislation, and cryptocurrency users in the U.S. would stand to benefit greatly from more regulatory clarity and a de minimus exemption for small transactions. Of course, there is no telling how the final bill will fare, given the notoriously distasteful process of legislating in D.C. Still, cryptocurrency users can find comfort in the fact that these great policy ideas are being given a fair shake on the Hill. If all goes well, they will a reality soon enough.