A quick question on virtual currency taxation

Bitcoin-is-a-bad-betI’m no tax expert, but it seems to me that the IRS ruling that digital currency will be treated like property rather than currency has widespread ramifications for those in the US. The reason is this. Capital gains on property are taxed at 15% while gains made through currency fluctuations are taxed at 23% (this is the 60/40 rule that sets the tax rate between capital gains and ordinary income).

One implication that this has is if you buy a coffee for $2 with a Bitcoin you bought previously for $1, you will have to declare that as a capital gain. Now for currencies, such as buying a coffee for $2 with a Canadian dollar you previously converted at a different exchange rate, this would not be an issue because, as I understand it, you wouldn’t strictly be trading in currency. That requires a currency to currency movement. At least that is what I am reading into this but then again I’m no tax expert.

Suppose for the moment, that Bitcoin has a stable value with respect to the USD. (If you don’t like that, imagine a virtual currency with a stable value in the future). Then if I wanted to speculate on the depreciation of the USD, what I could do is buy some Bitcoins today, and then immediate sell them from some Canadian dollars today as well. Then I wait and if the USD depreciates, I take my Canadian dollars and buy Bitcoins and immediately convert them to USD. Because it has all been used to buy an asset (Bitcoins) rather than a currency, it is not currency trading. So doesn’t that mean that the taxable rate would be 15% rather than 23%? Or, indeed, is there income — capital or ordinary — at all?

I have no idea and perhaps someone can enlighten me on this. But it seems to me that if you treat something that can work like a currency as an asset you are opening the door to having no currency trading at all.

(By the way, this is one of those posts where I expect to be proven a bloody idiot for even asking the question).

[Update: While I haven’t quite been called an idiot, a tax expert has got back to me to clarify a few things.

  1. Currency fluctuations are not taxed at 23%. The 40/60 rule is only applicable to certain traded future contracts. Of course, that means that if standardised futures on Bitcoins are traded in the future they will be subject to the 40/60 treatment. Had Bitcoin been classified as a currency the tax rate on all gains or losses attributable to value fluctuations would be at the top marginal bracket rate. So there is something interesting to watch here.
  2. The coffee hypothesis is not fully correct. If you buy a vacation home in Canada using CAD and the exchange rate fluctuates you are liable to tax on the exchange rate fluctuation at the 39.6% rate. Of course, this only applies if the gain or loss exceeds $200. So coffee is fine but spend more and there can be an issue.
  3. Will you be able to use Bitcoins to engage in broader currency speculation at a lower rate? Apparently not. If you hold CAD it does not matter how you got them. You are subject to tax on exchange rate movements based on spot prices at the time of trade. Again, this is at the personal tax rate though.

There are some murky things here but it is going to take some financial innovation on Bitcoin and other alternative currencies to see what really comes to play.]

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