That has left bitcoin enthusiasts—assuming they are interested in passing an IRS audit—in a legal no man's land.
So we spoke with Tyson Cross, an attorney in San Diego specializing in IRS compliance who has extensively researched bitcoin's tax implications since the currency blew up. His company is BitcoinTaxSolutions.com.
The Q&A has been lightly edited for brevity and clarity.
BI: Do you even need to report bitcoin income in the first place?
TC: Most people who take a sensible approach say it is taxable and reportable, so they need to make sure they're being compliant in their filing.
The question of whether bitcoins are taxable is really not much of a question at all if you look at the way income is defined, and the way courts have applied that definition, it reaches everything. If the guy who caught Barry Bonds' [record-breaking] home run ball had income from that, I'm sure you will have something coming for bitcoin.
BI: OK, so how should you report it?
TC: We've narrowed it down to two likely categories: as a foreign currency or capital gains item or a capital asset. So when choosing between those two alternatives, there's two considerations I tell people to make. The first is that capital asset has a very broad definition that almost certainly includes bitcoin. So reporting it as a capital gains is probably the safest route as far as meeting requirements of laws. On the other hand, while there's a much more narrow definition of foreign currency — and it'd be much more difficult to do that without taking a risk that the IRS won't agree — the tax you pay is higher. So there's an argument that it's safer to go that route, because if in the future the IRS decides it's a capital asset, then you're entitled to refund, and if they go the other way, then you don't have anything to worry about.
But if the IRS decides bitcoin is a foreign currency, and you were reporting it as capital gains, then you'd be responsible for that difference in tax.
BI: What if your assets are being held overseas?
TC: It doesn't matter where your income is, it's all taxable. If there was any income, it's taxable. But how you report holdings in general depends. Myself and other attorneys say cold wallets, paper wallets, aren't subject to reporting. But an account on a foreign exchange is holding not just bitcoins in your name, but also fiat. So if you've bought and sold in your name, anytime a foreign institution is holding something in your name it's taxable. So that's a big risk for people who deal in bitcoin, something few have maybe considered.
BI: What about at the state level?
TC: Typically most states follow whatever the federal government does, whatever the IRS does. In California, they basically follow every rule the IRS has, they pretty much just copy-pasted. A couple things might change, but you can expect states to go the same way in the future to whatever treatment the IRS applies. I'd be surprised if a state tried to take a different approach.
BI: What should bitcoin miners do?
TC: There are a couple different schools of thought out there. One group says you receive taxable income when bitcoin is first mined, once it's agreed on the Blockchain, and then again once you sell it; the other school says it's only taxable on the sale. I have a couple clients who do mining, and addressing the situation is hard—there's no clear answer to that, there's never been anything like bitcoin mining. At the current time, it depends on your exact situation, there is no one clear answer. It depends on which is more favorable to the client, and how risk averse they are.
BI: If the IRS makes a ruling after April 15, what then?
TC: A lot of people are concerned that it could be applied retroactively. An IRS regulation isn't a law, it's the interpretation of a law. And so basically the law is the same, but now the IRS is saying this is how we view it. So if you didn't do it correctly, you need to amend your tax return or pay it according to the new treatment. I don't think it's safe to say that just because the IRS hasn't hasn't given guidance you don't have to file.
As a practical matter you probably can expect to get some leeway if you do file, because it's just so complicated, so difficult to figure out the treatment, I would be surprised if the IRS dropped the hammer on people who made an effort to accurately report their income.
BI: Has there been any indication of when the IRS will rule?
TC: The IRS says they're looking into it. If you recall, for a long time there was issue over airline miles, and it was years before they came out with a clear stance. That is very simple compared with bitcoin, so I don't know when they would come out with a response.
See also: Warren Buffett: Bitcoin Is a Mirage