By now most everyone has heard of bitcoin. But exactly what is it? And how should it be taxed?

Bitcoin is usually described as virtual currency. That’s useful shorthand, but is it really money? And should it be taxed as if it is? Or is it a capital asset? How about a commodity? And then there is the matter of using this quasi-cash to avoid taxes and regulation altogether.

The IRS says it is studying the matter but has yet to issue any guidance. Until it does, it is anyone’s guess how bitcoin should be taxed. Most users/investors will simply pick what is most beneficial to them when they file their 2013 returns.

At the moment, bitcoin and its cousin currencies have had far more success generating buzz than facilitating commerce. Yet, the idea of online money can’t be ignored.

Curiously, the motivating force for the IRS to issue guidance may be an effort by Cameron and Tyler Winklevoss (best known until now for their legal battle with Mark Zuckerberg over Facebook) to create an exchange-traded fund to track bitcoin prices. The twins are awaiting SEC approval for their ETF but their very request raises important tax policy questions that need to be answered.

Back in November, Mindi Lowy and Miriam Abraham of PriceWaterhouseCoopers wrote a terrific review of the current state of play for Tax Notes Today (requires a subscription). They concluded that for now virtual currency would probably be viewed as a capital asset since it has limited use as real money. However, should these vehicles gain wider commercial acceptance, they’d more likely be treated as actual currency for tax and regulatory purposes.

The distinctions are not trivial.

If bitcoin is a capital asset (the Winkelvoss ETF would treat it that way), long-term gains and losses would be subject to preferential capital gains rates (23.8 percent for high-income taxpayers). However, losses of more than $3,000 could only be used to offset other gains and not ordinary income. Separate rules may apply to professional traders.

What if bitcoin is a currency for tax purposes, the same as, say a euro? In that case, profits from sales would be taxed as ordinary income, with a top rate of 39.6 percent, though all losses could offset other income.

Either way, the mere act of buying something would likely be a taxable event. As Lowy and Abraham note, this would be something of a surprise to consumers.

Similarly, mining bitcoin (the process of obtaining the currency by solving a math problem) would also trigger tax. Taxing bitcoin would also require users to track cost basis—not so easy at the moment, although Bloomberg has begun publishing prices.

Get the Monitor Stories you care about delivered to your inbox. By signing up, you agree to our Privacy Policy

Then there is the matter of using virtual currency to avoid all tax—as well as other laws. Last Thursday, theWall Street Journal’s Danny Yadron wrote a fascinating piece about Cody Wilson, the guy who made himself famous by posting online instructions for making plastic guns from 3-D printers. Wilson says he is working on software called Dark Wallet that would defeat the government’s ability electronically track bitcoin transactions. While Wilson and others see this as a Libertarian protection against government, others see it as simply a way to make it easier for people to deal illegal drugs or evade taxes.

For now, bitcoin is little more than a marketing fad, an ideological metaphor, and a sandbox for speculators. But virtual currency isn’t likely to go away. It would be useful if users didn’t have to guess at its tax treatment.