The Rise of Virtual Currencies
Over the last few years, Bitcoin and other virtual currencies, such as Ethereum and Litecoin have gained enormous popularity with both individuals and businesses as a new and convenient way of making both purchases and even person-to-person payments.
There are growing believers that Bitcoin itself is an economic singularity, which is the belief that everyone around the world has incentives to use Bitcoin, and it makes the world a better place.
Bitcoin disciples are known to use Bitcoin as their exclusive currency wherever possible, in hopes to completely replace the use of traditional or fiat currencies.
Price speculation is very different from Bitcoin’s usefulness
It’s also no secret that most of the well-known virtual currencies have experienced massive increases in their market value. As of this post, Bitcoin sits at near $5,700 per coin, that’s a 52% increase in the last month and 760+% increase over the last year.
Courtesy: Coinbase
Two things are clear:
- Society is becoming more comfortable with using virtual currencies in everyday purchases and remittances.
- At the moment, people are getting rich on speculating on the value of these assets.
I am separating the topic of using digital assets for payments, from speculating on price appreciation of these assets. I have no opinion on the value of these assets. I leave that to the speculators.
Instead, my focus will be on whether these assets are treated as true currencies according to the IRS, and what are the tax implications of this treatment.
Virtual currency payments are convenient and approaching mainstream
Virtual currency wallets now make buying, selling and even transferring digital coins very convenient. For example, Coinbase, a popular digital coin wallet application, is said to be attracting 1 million new users per month.
Coinbase subscribers can use their wallet to seamlessly transfer digital coins to another person. Virtual currency transfers have become a quick and convenient alternative to making fiat currency payments.
But, not all payments are created equal
Assuming these digital coin transfers are being done as some form of payment, it’s time for a reality check. There could be unique implications if you replace fiat currencies with virtual currencies when making certain person-to-person payments.
Fact: the United States Government does not recognize ‘virtual currencies’ as legal tender. Instead, the IRS treats them as property (similar to how gold, art, or securities are treated). This is an important distinction:
In situations where a person who makes certain payments in US dollars (cash, check or money order) who would ordinarily be eligible for tax deductions on these payments, would not be eligible for the same tax deduction on the similar payments made with Bitcoin, Ethereum, Litecoin, or any other virtual currency.
Making payments with virtual currencies can have unintended consequences
The following example highlights how making payments in virtual currencies can have reprocussions:
Jane and Mike are divorced. Jane pays Mike $1,000 in alimony per month, by check. According to their stipulation agreement, divorce decree and the IRS: IRC rule §71(b)(1)(A)&(D), Jane is allowed to deduct these alimony payments on her tax return. Conversely, Mike reports these alimony payments as income on his tax return.
Mike and Jane are collaborative co-parents and are both very comfortable in transacting in virtual currencies. They both believe in Bitcoin as an economic singularity. In effort to reduce their reliance on ‘old-school’ fiat currencies run by ‘evil’ banks, Jane has offered to send $1,000 per month in Bitcoin to Mike in place of a check. Mike thought that this was a good idea and agreed to the change.
Regardless of what Mike and Jane agreed on, according to the IRS Virtual Currency Guidance, Jane is no longer eligible to deduct these alimony payments on her tax return. This is because she did not use an IRS recognized form of payment, which is exclusively ‘cash, check or money order’.
Small change, big impact
This small change in how Jane made alimony payments had a potentially big negative impact on her tax return. Jane is likely to be in a worse financial situation simply by making the same alimony payments, just in a different form. For more details on the IRS interpretation of eligible alimony payments, go to IRS publications; scroll to paragraph 17, chapter 18.
Also, depending on how the Bitcoin was originally acquired in the above example, there is another tax matter associated with capital gains that either Jane or Mike could liable for. I will cover that in another article.
An important lesson
It’s critical to understand that in some cases, the convenience of using virtual currencies has outpaced some of it’s realistic usefulness. There is fragmented adoption to recognize these virtual currencies as true ‘currencies’, particularly in government tax and regulation.
So, If you are an avid Bitcoin or alt-coin user, you shouldn’t blindly assume that your virtual currency wallet can replace everything you do with you bank account (at least, not yet). In certain scenarios, you could stumble into an unwanted tax trap. If you want to change the way you make certain payments that show up on your tax return, always check with your accountant first.
In summary
While consumer adoption of virtual currencies increases daily, uneven regulatory adoption means that using virtual currencies to make certain payments is not always beneficial. The IRS concludes that virtual currencies ‘do not have legal tender status in any jurisdiction’.
As such, Bitcoin, Ethereum and Litecoin, etc.. all are classified as property, not currency. There are potential tax implications to this different treatment.
Virtual currency users, beware.