The IRS has issued its long-awaited stance on the tax treatment for virtual currencies like Bitcoin (IRS Notice 2014-21).  In short, the taxpayer must treat Bitcoin as property for federal tax purposes. The effect of this decision on the viability of the virtual currency is unclear, and small businesses accepting Bitcoin, and their accountants, are scratching their heads as to how this classification will play itself out for daily transactions.
 
The IRS is not alone in denying Bitcoin the exalted status of legal tender. At the moment, not a single country recognizes Bitcoin as a currency.  So while enthusiasts envision a day where Bitcoin is the ubiquitous medium of exchange, that date has been pushed back.  

Here are a couple examples of how the tax principles that apply to regular property transactions would also apply to transactions using virtual currency like Bitcoin.  

Let’s say you were one of the first Bitcoin adopters and bought 5,000 bitcoins at US$0.05.  Last year when Bitcoin was valued at roughly US$1,000 in fiat, you traded 250 of them for a brand new Lamborghini.

The IRS would say that your cost basis was $12.50 for those 250 coins.  Since you traded them for other property with a fair market value of $US 250,000, you have a taxable gain of $249,987.50.  Total buzzkill.
 
Changing the $250,000 Lamborghini in our example to a $5 cup of coffee at Starbucks would require a recognition of capital gain every time you went in for your caffeine fix. Anyone who uses Bitcoin for trivial transactions would have to deal with a record-keeping nightmare absent diligent preparation and/or third-party services.

Washington-based Avalara, a leading developer of online sales and use tax automation software, has launched a system for supporting Bitcoin other virtual online currencies. Webb Stevens, Head of Product at Avalara, noted the widespread impact of the use of Bitcoin on a transactional basis.

“If you use Bitcoin, third-party integration will be needed for transactions,” said Stevens. “It is important for keeping track of accounting and sales taxes across 12,000 tax jurisdictions."

For now, only the most cutting-edge corporations like Overstock.com and a select group of forward-thinking small businesses scattered about the country accept Bitcoin directly for transactions.  

But with user adoption expected to grow, more and more consumers and businesses will be holding the currency, and their accountants will be waiting patiently for further guidance from the IRS.  

View the IRS’ general rules, listed in a series of 16 frequently asked questions (FAQs)