Does the IRS really want you to track your capital gains on bitcoin every time you buy a sandwich or a sweater in the digital currency?

After our analysis of the Internal Revenue Service guidelines on bitcoin, released in March, some people expressed surprise.

They were amazed that the IRS could seriously be applying capital gains rules to something that the bitcoin community sees as a currency, and which in many cases uses as such.

“This can’t be good for bitcoin”, said one commenter privately to Coindesk. “If it’s not a currency, then how are you supposed to use it like one?”

But as far as the IRS is concerned, it isn’t a currency – it’s property, pure and simple. And the laws for tax on property are already pretty clearly defined.

When dealing in currencies, you declare the foreign losses and gains if you exchange them for another currency. But when you’re dealing in property, then whenever you’re trading it for something else, you declare the capital gains taxes that you have incurred.

This can be a good thing for investors who are in it for the longer term. They will end up having to pay long-term capital gains tax when exchanging their bitcoins for fiat currency, as long as they have held those bitcoins for longer than a year and a day. If they have held them for shorter than that, then they will pay short-term capital gains tax, which is the same as the ordinary income tax rate.

We double checked this with several people, including Keith A. Aqui, who wrote the IRS Notice. “When you exchange property for other property, then you have to declare, because it’s a capital asset,” he confirmed.

We also spoke to another IRS spokesperson with the authority to speak about these matters. Said the staffer, who did not want to be named:

“You’re not a dealer, if you’re a typical person, whether you call yourself an investor or not, that is essentially what you’re going to be under the tax code. So if I have 10 bitcoins sitting around and I use them in a transaction and I realize a gain from the transaction compared to the original price, I will pay tax on that gain, as a capital gain.”

Richard Peterson, chair of Perkins Coie’s tax practice, also confirmed the interpretation, pointing to Q&A No.6 of the IRS Notice on the subject.

“It makes clear that using the bitcoin as a payment triggers taxable income. The type of income would depend upon how the bitcoin was being held by the person making the purchase,” he said.

“If that person was an investor, the gain would still be capital gain, the same as if they had cashed in the bitcoin and then spent the cash at the retailer.”

The only way around this is if an an exception applies to make it ordinary, such as classifying the bitcoin as inventory. However, it would not be inventory in the hands of a consumer, he said.

This also has sticky connotations for firms wanting to pay bitcoins in wages or to buy services with it, confirmed another spokesperson for the IRS. He said:

“There is a capital gains obligation there. It doesn’t matter if you’re holding them to pay someone’s wages or not, any non-dealer has a tax obligation, if there are gains.”

It’s already the law

Anyone questioning this further need only look to existing tax law, said Bryan Smith, a colleague of Peterson’s and a partner with the firm’s business practice. The IRS is simply applying it to virtual currency, he points out.

Said Smith:

“Unless a specific exception applies, if you use any asset other than cash to make payments of any nature, you have taxable gain. The Notice doesn’t make this the law. It already is.”

In reality, though, it’s going to be extremely hard to police that law. “Most people want to be tax compliant, but at a certain point people will throw their hands in the air,” said Tyson Cross, a tax attorney working in San Diego who specialises in advising people about bitcoin tax issues.

The concept of capital gains on tiny transactions is difficult to enforce, and enforcement is going down, not up. The IRS has released its latest statistics on the number of audits carried out. The overall audit rate in 2013 was 0.96%, which is the lowest since 2005.

Where it does audit people, it tends to go after big fish, with big transactions.

The highest percentage of people audited in 2013 with an income under $200,000 was the $0-$25,000 bracket. Of which 1% were nobbled.

Above $200,000, the rates keep rising, all the way up individuals with more than $10m in earnings on their tax returns for the year, where almost a quarter of people were audited.

Among this super-rich set, it will be presumably be looking for capital gains taxes on large property transactions (including large amounts of bitcoin).

The chances are that most bitcoiners using the digital currency (or property, depending on which government agency you’re talking to) for daily transactions aren’t going to be worrying too much about this in daily practice.

Nevertheless, if someone were to develop a mobile app with functionality built-in to track those capital gains taxes on bitcoin purchases, it might well appeal to a broad audience.

Would you use one?

Statements in this article should not be considered tax advice, which is best sought directly from a qualified professional.

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