As most people have now heard, the IRS just granted itself the power to tax the gains realized when individuals sell or spend their bitcoins — much like stocks. That means you are also responsible for knowing exactly how much your Bitcoin holdings have increased in dollar terms since you bought them. If you are a miner, it even means all those 1’s and 0s sitting idly on your cold storage hard drive are now considered gross income. Naturally, this has produced some trepidation among Bitcoin lovers, who now are obliged to keep incredibly onerous tax records if they want to stay on the right side of the law.
Compliance will almost assuredly be an ongoing issue, given the private nature of the technology. “While users with sizeable Bitcoin wallets might be motivated to comply with the new policy, those with smaller wallets might not find the hassle worth their time,” noted the Tax Foundation in a recent blog post on the ruling. But there may be some unforeseen issues for the IRS — and benefits for Bitcoin users. Given the inherent difficulty with enforcement, the IRS ruling could backfire if more people self-report their Bitcoin holdings as capital losses (in order to gain tax benefits) than capital gains.
If that happened, Bitcoin could essentially become a tax loophole. With the reliance on self-reported Bitcoin holdings and the anonymity of private wallets, the government may need an army of cryptographers and a substantial increase in audits to ensure compliance from small-time Bitcoiners. As with pirated movies and software, enforcement would need to be so draconian it is likely infeasible.
Better yet: if the Bitcoin community managed to change the protocol to increase the rate that miners can “unlock” new coins… Bitcoin might have a built-in incentive to both adopt the currency and report taxable earnings. Let’s say that we accepted an inflationary Bitcoin, much like we have an inflationary dollar, around 2 or 3 annualized. At the end of the year, a consistently inflating bitcoin would trigger no capital gains liability, only capital losses, reducing the tax liability of the filer.
If this held, then Bitcoin could actually trigger regular refunds of varying quantities for both hoarders and spenders alike. Businesses large and small, as well as ordinary consumers could essentially earn a reduced tax burden every time they used Bitcoin, as long as its value kept falling.
Of course, proceeds from Bitcoin sales would still have to be reported, but that is less of a problem than reporting every single capital gain throughout the year. So inflation could mitigate the worries that many Bitcoin businesses and investors have about the new IRS rules.
A perpetually inflating Bitcoin would also be great for miners, in that it would both reduce the cost and increase the incentive to continue mining. It would also be great for law enforcement, since it would encourage voluntary tax compliance. This would also reduce the reporting burden for bitcoin users and add a little extra incentive to use the cryptocurrency. Everybody wins!
If the Bitcoin protocol doesn’t change in this respect, some other cryptocurrency might realize a potential competitive advantage here and take its place as the electronic money of choice. Many economists have already pointed out that a deflating Bitcoin is going to stifle adoption. The IRS ruling will likely only make that worse, forcing the Bitcoin community to improvise.
At the end of the day, Bitcoin is a very unique tool with properties of both an asset and a currency. In that sense, it remains malleable, and with sufficient momentum, may continue to outwit attempts to control or stamp it out. “While the IRS has finally provided an answer,” said the Tax Foundation, “there are good reasons to believe that they got it wrong. Virtual currencies are tricky assets to categorize.”
As Princess Leia said to Governor Tarkin in Episode IV: “The more you tighten your grip, Tarkin, the more star systems will slip through your fingers.”
If the IRS starts to tighten that grip too much, expect Bitcoiners to start syncing up those wallets.
Author’s Note: Matt McKibbin of Liberty Panacea contributed to this post