Why is Digital Currency Taxable?

Hundreds of thousands of Americans are breaking the law at tax time, and they don’t even know it. I’m not talking about the estimated 5% of Americans that submit their taxes late; we all know someone who has fallen short of the last minute scramble to file before the mid April deadline. I’m talking about the growing number of Americans that have started using bitcoin without reporting their gains to the government. Because you know what’s worse than paying a late fee? Being investigated by the IRS for not reporting an extremely lucrative alternative form of investment.

While there’s been some media fanfare over the ongoing Coinbase / IRS trial, and some hints and tips bandied around by CPAs-turned-blockchain aficionados, the fact is that most Americans don’t know how to report their digital currency portfolio gains to the IRS and State, or simply choose not to. Fortune reported recently that of the estimated hundreds of thousands of bitcoin users across America, only 802 individuals reported gains at tax time. It’s a staggering statistic; one that is muddied by the loose guidelines around bitcoin at present, and the few options users have in meeting their reporting obligations accurately and transparently.

Not all of us realize that despite the exponential adoption of digital currency across the country, and the vague IRS guidance issued over three years ago, law still applies. Every trade made is a taxable event.

When we address the growing rate of digital currency adoption and America’s gross failure to comply at tax time, the biggest challenge is the lack of legislation. The IRS notice in March of 2014 titled “IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply,” shows that we are dealing with property, not currency. The accompanying FAQ answers some questions for the savvy taxpayer, but it falls short in some key areas, mostly around cost basis and multi-party trades.

Two scenarios trigger a taxable event: mining and trading. In both cases, assigning the proper (or the most effective) cost basis to the currency you receive plays the single most important role in your tax obligation. Miners, who use state of the art computers to brute-force crack mathematical algorithms for block rewards, derive an income (in fact, a total of $2 billion USD has been earned from bitcoin miners since 2008), but are they subject to tax?

The IRS says yes, but determining the cost basis is not entirely clear. Here, the currency is treated more like fiat currency with the requirement that income tax be paid on the value received. Yet, it’s still property and because it wasn’t purchased there’s a gray area for the value. This question is directly addressed by the IRS in allowing the receiver to determine basis “in a reasonable manner that is consistently applied” but only in the context of an exchange. While bitcoin may be traded on all exchanges, not all digital currencies are. From this, we start to form questions that are currently unanswerable by the average American: What exchange do I use? What happens if the exchange I was using no longer trades my currency? Can I use a group of exchanges for cost basis and always use the lowest value or the highest value, so long as I’m consistent? One may argue it is “reasonable” for me to lower my tax obligation wherever possible. For basis, can I use an exchange that I am politically restricted from trading on? Persons in New York State cannot trade on most exchanges yet the most “fair” market value may come from a high volume exchange outside of NY.

When it comes to trading digital currency, does a taxpayer have a gain or loss when exchanging virtual currency for other property? Here, the IRS says yes and again leaves the calculation of basis up to the trader. The same questions about mining apply with a few new ones. With a trade, the true cost basis is known but is still assignable based on exchange rates if you choose to do so. However, a blockchain trade does not operate or follow the same principles of stocks, bonds, or other investment property. Blockchain trades must comprise full lots, always. If you buy 11 bitcoins in one transaction and later sell 2, the sale comprises all 11 bitcoins, transfers 2 to wherever you stated and returns 9 back you. Those 9 bitcoins are then eligible for use in future trades. Determining basis might appear straightforward but it’s not. The location of the “change” is in a different address with a different private key. Does this constitute a sale and a buy? What should the basis of the change be? The fairest is probably whatever the basis of the original 11 was, but the IRS currently offers no guidance. If we assume that the most appropriate action to take is to carry forward the basis until the full balance of the original 11 bitcoins reaches zero, and the IRS decides to issue that guidance, it gets even more complicated if we throw another buy into the mix. Pretend we buy 1 new bitcoin, bringing our total to 10 and then sell 9.5. Recall, all 10 comprise the sale, 9.5 are sold and .5 returns as change. Now, what is the cost basis of the .5? Which lot did it come from, the 9 or the 1? This is important because the basis of each lot may be vastly different. One may result in a loss, the other a gain. Again, the IRS is silent on this.

Keep in mind that not all trades are sales in the traditional sense. Some trades just consolidate many lots into one. And some trades are made by single users into multiple wallets. Basis of the consolidated lot is nearly impossible to assign if the lots that were consolidated comprised different bases and were held for varying amounts of time.

When regulation does eventually answers these questions, it will forever alter the way investors interact with their holdings. It’s also likely to spur investment-centric design considerations when developing digital currency wallets. Presently, there are no wallets that factor in cost-basis when forming trades, perhaps because tax burden was not part of the conversation and even if it was, there were and still are, too many unknowns. In the meantime, digital currency users need to report their gains to the IRS. That means every American that received even one block reward, or made just one trade has to come clean. If they don’t, they shouldn’t be surprised when they receive a terse letter in the mail.

Originally published at Nasdaq