The U.S. government will treat Bitcoin as property for tax purposes, applying rules it uses to govern stocks and barter transactions, the Internal Revenue Service said in its first substantive ruling on the issue.
Today's IRS guidance will provide certainty for investors, along with potential income-tax liability. Under the ruling, purchasing a $2 cup of coffee with Bitcoins bought for $1 would trigger $1 in capital gains for the coffee drinker and $2 of income for the coffee shop.
The IRS, faced with a choice of treating Bitcoins like currency or property, chose property.
"The danger is the creation of an electronic black market, similar to the cash economy," Joshua Blank, a tax law professor at New York University, said in a December interview. "That's what the IRS wants to avoid."
Bitcoin, the most popular digital currency, emerged from a 2008 paper written by a programmer or group of programmers under the name Satoshi Nakamoto. The Bitcoin network uses a public ledger to record transactions made under pseudonyms, a technological breakthrough that allows purchases and sales without using a trusted third party, such as Visa Inc. or Western Union Co.
Powerful computers that record the transactions and guard against double-spending the same currency generate new Bitcoins, a process referred to as mining. Mining has made some early Bitcoin adopters wealthy in dollar terms.
Under the IRS ruling, Bitcoin investors would be treated like stock investors. Bitcoins held for more than a year and then sold would pay the lower tax rates applicable to capital gains a maximum of 23.8 percent compared with the 43.4 percent top rate on property sold within a year of purchase.
For investors with losses, U.S. tax law allows taxpayers to subtract capital losses from any capital gains. They can also subtract up to $3,000 of capital losses a year from ordinary income.
As with stocks, Bitcoin dealers would be subject to different rules that wouldn't allow for capital gains treatment.
Bitcoin miners would have to report their earnings as taxable income with a value equal to the worth on the day it was mined. If they mine as part of a business, they would have to pay payroll taxes as well.
The IRS will require information reporting similar to how the tax agency receives notification of stock transactions and payments to independent contractors.
The ruling takes effect immediately and covers past and future transactions and tax returns. The IRS said in the notice that it may offer relief from penalties to people who engaged in transactions before today and can show "reasonable cause" for any underpayments or failure to file.
The ruling comes fewer than three months after National Taxpayer Advocate Nina Olson said the IRS should issue guidance to taxpayers on digital currency transactions.
"It is the government's responsibility to inform the public about the rules they are required to follow," Olson, who runs an independent office within IRS, wrote in her annual report to Congress in January. "The lack of clear answers to basic questions such as when and how taxpayers should report gains and losses on digital currency transactions probably encourages tax avoidance."