Yes, Bitcoin is legit, says IRS. But tax reporting could be boggling

Now that the Internal Revenue Service has weighed in on Bitcoin, the faddish digital cash making recent headlines for bankruptcies at its exchanges, some users are celebrating, while others wonder if going legit will kill the new crypto-coin completely. 

Under its new ruling, the IRS proposes treating the digital cash as an asset or commodity, such as a stock, instead of deeming it a pure currency, such as dollars.

“We are very excited about this opinion,” says Erick Watson, chief operating officer of New Path Mining, a Bitcoin mining firm in Seattle, Wash. The most important reason, he adds, is what it says to the larger financial community.

“This decision legitimizes Bitcoin both as a transaction medium and as an asset,” Mr. Watson says. Bitcoin has been seen as a tool for illegal activity, he says. But this statement from a federal agency says that the government recognizes the currency and is working on strategies for how to treat it.

“Now that the IRS has made a public statement about the currency, this takes the uncertainty out of the marketplace,” he says.

But analysts say that Bitcoin's new legitimacy has a formidable downside, as users face new IRS reporting requirements.

This may be a step forward for legitimacy, but “it’s a giant leap backward for practicality,” says Gemma Godfrey, head of Investment Strategy at Brooks Macdonald in London, via e-mail.

While the IRS opinion may be a boon to investors, it just added a boggling new burden on anyone who might want to use the virtual tender to actually buy something, she adds. “Working out tax implications every time it’s used would prove highly impractical."

 One of the attractions of using Bitcoin in everyday life is its convenience and ease of use, says Arnav Sheth, assistant professor of finance at the graduate business school of Saint Mary's College of California in Moraga.

Much like cash, Bitcoin can be transferred from one party to another quite easily and without much hassle. After the new IRS ruling, the accounting for it is going to become much more difficult, he adds.

Moreover, taxing Bitcoin as property can amount to double taxation. "Say you buy a sushi dinner for your family at an expensive restaurant for $600,” which at today’s prices is roughly one Bitcoin, says Professor Sheth. “If you paid $10 to buy that 1 BTC, you are now liable for taxes on the excess $590,” in addition to the taxes you pay to the restauranteur.

“There's the troubling double-taxation aspect,” he adds. "You're paying Uncle Sam twice: once for your Bitcoin and again for your dinner. In addition to that, it is now much harder for you to keep track of how much you will spend and how much you owe in taxes.”

Try to minimize your tax, and the accounting burden gets heavier still. “Suppose I own 2 BTC,” he says. “Now I have to figure out which one I should use to minimize my taxes. How much did I pay for each? How much was that dinner again? You can see that it gets pretty complicated pretty fast,” he adds.

Bitcoin backers say that these obstacles are not insurmountable, especially if Congress steps in to delay implementation of the ruling until the tech community can catch up.

The barter economy, or trading property for a product, is certainly not a new idea, says CPA Steve Brecher, senior adviser at WeiserMazars in New York. “There are more and more exchanges for different kinds of property,” he says, noting that the marketplace has worked out methods for determining quotations of value and doing the necessary calculations for reporting. 

Moreover, with the high level of involvement from the tech community in the evolution of Bitcoin, the challenges of every day usage can be met, most likely with a new application or something similar, says Watson. “This is a tractable problem,” he adds.

However, given the lack of such software at the moment, the new ruling leaves the average user in a grey zone, says Steve Kirsch, CEO of Cointrust, a company that is developing technology to address the compliance and safety issues associated with virtual currencies.

“It would be best for Congress to get involved at this point and either suspend the implementation of this ruling to allow the applications people use to catch up to the ruling or treat Bitcoin as a currency for tax purposes,” he adds via e-mail.