This is Part Three in a Seven Part Series Covering Taxation of Bitcoin for US Citizens
Written by Tyson Cross a Tax Attorney based in San Diego
Part One – Tax Realization of Bitcoin Gains
Part Two – Tax Recognition of Bitcoin Gains
Part Three- Tax Character of Bitcoin Gains You are Here
Part Four – Tax Losses and Bitcoin
Part Five- Tax Deductions Related to Bitcoin
Part Six- Tax Record Keeping related to Bitcoin
Part Seven- Bitcoin Foreign Account Reporting Requirements
#14: Are my gains “capital gains?”
Probably. The first hurdle to clear is the classification of bitcoins as a capital asset, because capital gains treatment applies only to capital assets. This is actually a pretty easy hurdle to clear because the definition of a capital asset includes all forms of property by default, unless specifically excluded. So, if you look at the list of excluded property under § 1221(a) of the code, you’ll see that bitcoins are not excluded by name, nor would they fall within any of the excluded categories. (keep in mind that this is not true if bitcoins are held as inventory in a trade or business, which might be the case if you mine bitcoins, nor is it true if bitcoins are classified as a self-created intangible asset like a copyright, which is unlikely but possible).
Thus, bitcoins are a capital asset in the hands of most taxpayers and qualify for capital gains treatment. If you were lucky enough to buy your bitcoins more than a year ago, then your gains would qualify for the lower preferential tax rate given to long term capital gains (probably 15%, but it depends on your income level).
If you held you bitcoins for one year or less, then the gains are characterized as short term capital gains, which are taxed at ordinary income tax rates (i.e. the same rate as your paycheck).
Note that a different characterization would apply if bitcoins are treated as a foreign currency. Whether bitcoins will be so treated is uncertain, but if you’re curious, read the answer below.
#15: What if I mined my bitcoins?
As mentioned above, the tax treatment of bitcoin miners is very uncertain. The primary question here is whether you are engaged in a trade or business, and if so, whether your bitcoins should be classified as “inventory.” If the answer to both of these questions is “yes,” then your bitcoins are not capital assets and your gains are taxable as ordinary income. If the answer to either of these questions is “no,” then your gains are taxable just like a normal investor (i.e. as capital gains).
Unfortunately, there is no clear answer to these questions. For some bitcoin miners the answer will be yes, for others it might be no. The tax treatment will depend on the specific facts and circumstances of your case, although the bigger your mining operation, the more likely it should be treated as a trade or business (and therefore taxed at ordinary rates). I suggest consulting with a competent tax advisor to determine whether your mining activities rise to that level.
#16: What if I’m a “day trader?”
Generally, the tax treatment for day traders is the same as a regular investor. Of course there are exceptions to this rule, such as the mark-to-market regime, but these exceptions are narrowly defined by statute and would not apply to bitcoins without some action by the IRS or Congress.
There is also the possibility that your day-trading activities could rise to the level of an actual business (which would make your gains and losses “ordinary,” among other effects). The IRS is extremely stingy when it comes to classifying day-traders in this manner, though, so it’s unlikely you have anything to worry about here. However, you should consult with a tax advisor to be sure about your status.
#17: What if Bitcoins are classified as a collectible?
As a collectible, the gains would still be “capital gains,” but the lower tax rate given to long term capital gains would be fixed at 28% (instead of the 15% most taxpayers would use). However, it’s pretty unlikely at this point that bitcoins would be classified as a collectible. This is because the tax law provides a list of items that are “collectibles,” and bitcoins are not specifically named in that list. Additionally, “collectibles” are traditionally tangible assets, whereas bitcoins are intangible assets. Thus, for now, it’s safe to conclude that bitcoins are not a collectible and regular long-term capital gains treatment applies.
Note: there might be an argument that physical bitcoins, such as those made by Casacius, are “collectibles.” However, that would still require some determination by the IRS that they are actual “coins.”
#18: What if bitcoins are treated as a foreign currency?
As a foreign currency, bitcoins would be disqualified from capital gains treatment (even though still technically a capital asset). In other words, all bitcoin gains would be taxable at ordinary income tax rates regardless of holding period. Although that sounds like bad news for bitcoin investors, there are some caveats that arguably outweigh the negatives of this outcome.
The biggest is the exception under the foreign currency rules for “personal transactions.” Under this exception, gains of less than $200 are tax free as long as the transaction is not for investment or business purposes. Remember that without this exception, every exchange of bitcoins for goods or services would trigger taxable gain, which creates a significant burden on the use of bitcoin for day-to-day transactions. Thus, this exception is a potential game changer for the future of bitcoin. Assuming that most consumer transactions would 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 cannot be overstated.
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 a benefit to consumers who use bitcoin for day-to-day personal transactions.
Just to be clear, any gains on non-personal transactions would be ordinary income. So, investors would lose the lower tax rate given to long-term capital gains. However, this isn’t as bad as it sounds. First, many investors – particularly day traders – do not hold bitcoin for longer than one-year anyways, so their tax rate is effectively unchanged. Second, because they are no longer “capital,” bitcoin losses would be fully deductible (i.e. not subject to the $3,000 limitation discussed below). Finally, investors stand to benefit if we assume that the personal transaction exemption would help propel the wide spread use of bitcoin, which is likely to be the greatest catalyst for future market appreciation.
#19: So, is bitcoin foreign currency?
It is impossible to say at this point whether bitcoins are a foreign currency for purposes of income taxation. No US court has directly addressed this issue, nor has the IRS published any guidance. The closest we’ve come is an obscure federal court decision written by a Magistrate judge involving bank fraud chargers (which has nothing to do with taxation) and a ruling by FinCEN that Bitcoin is not a currency. However, the FinCEN ruling uses an extremely narrow definition of currency that has no application whatsoever to the issue of taxation.
Thus, bitcoin users and tax professionals are left to guess as to its proper classification. When dealing with uncertainties such as this, it is generally advisable to proceed with the most cautious option available until some further guidance is issued by the IRS. In this case, that would be treating bitcoin as a normal capital asset.
However, this is not to say that you would be unreasonable for treating bitcoin as a foreign currency. Indeed, bitcoins are intended to serve as a medium exchange and lack any other functional purpose. Unlike gold, silver or other commodities that have served as currency in the past, bitcoins do not have any industrial or commercial usefulness aside from exchange. This arguably makes them much more similar to a currency than a commodity or other capital asset.
Of course, the fact that bitcoins are not minted by any foreign government or bank casts some doubt as to whether they are truly foreign currency. However, the Internal Revenue Code does not actually employ the term foreign currency. It distinguishes currency as being functional or nonfunctional, and only the US dollar can be a functional currency. Thus, the fact that bitcoin is not produced by a foreign government is not actually relevant, because any currency that is not the US dollar is automatically a non-functional currency and therefore subject to the foreign currency rules. The only question is whether it’s proper to categorize bitcoin as a currency in the first place
In the end, the decision of whether to treat bitcoins as a foreign currency is up to you (and your tax advisor). The trouble is that the IRS could subsequently try to undo your elected treatment and assess the additional tax that would result. Of course, it’s possible that the IRS will ultimately agree with this treatment, in which case you would not be at any risk by adopting it early. I wish I could provide a more concrete recommendation here, but at this point it’s just too uncertain.
The character of your bitcoin gains or losses is most likely “capital.’ If bitcoins are determined to be a foreign currency, however, the characterization would be different. Additionally, there are other exceptions that might apply (particularly if you are a bitcoin miner or a very active day trader).
Continue to Part Four: Bitcoin Tax Treatment of Losses