“For federal tax purposes, virtual currency is treated as property.”
With those ten words, the IRS has made it more difficult — if not impossible — for bitcoin and other virtual currencies from gaining widespread, mainstream acceptance as a currency for commercial transactions. Because they are now treated as property, virtual currencies are considered, like stocks, bonds, and other investment property, as capital assets and will be subject to capital gains tax.
But why does this hinder bitcoins use a currency? The answer is fungibility: Bitcoins are no longer completely fungible.
Fungibility is the property of a good or a commodity whose individual units are capable of mutual substitution. For example, since one ounce of gold is equivalent to any other ounce of gold, gold is fungible. Similarly, a $10 bill is not only interchangeable with another $10 bill, it’s also interchangeable with two $5s, ten $1s, and other combination that adds to 10. Fiat currency is completely fungible.
And from the seller’s side of an exchange, so are bitcoins. If you owe me 1 bitcoin for lunch, I don’t care if you give me a bitcoin you acquired last year or one you acquired yesterday. To me, they are completely equal and thus completely fungible. But they would not be completely equal to you.
Say you bought bitcoin A for $10 last year and bitcoin B for $550 yesterday. Today, however, a bitcoin is worth $530. If you trade bitcoin A you had a capital gain of $520. But if you use bitcoin B, you’d have a capital loss of $30. Since you’d have to pay the capital gains tax if you use bitcoin A, you’d be better off using bitcoin B.
While such considerations may not be a hassle for those who have few bitcoins, rarely spend them, or refuse to pay taxes, they become onerous for those who have many bitcoins, uses them frequently in exchanges, and fear IRS audits. “If I have to figure out which particular Bitcoin in my wallet I want to spend and what the tax treatment will be, Bitcoin just doesn’t work as a commercial medium of exchange,” says Adam J. Levitin, a Georgetown Law professor and expert on finance and payments.
Several weeks ago I wrote that, as a currency, bitcoin was (nearly) dead. With this IRS decision, though, I think it’s safe to say it’s mostly dead (as Miracle Max would say, “There’s a big difference between mostly dead and all dead. Mostly dead is slightly alive.”). You’ll still be able to buy a sandwich with bitcoins. But the new IRS rule means the transaction will be more like paying for lunch with a share of Google stock than with a wad of dollar bills.