Bitcoin is it an online payment system? A digital currency? Is it a commodity or is it property? Is it all of these things or none of these? Most governments, including the United States, do not consider Bitcoin “real” currency. I don’t mean the Brazilian Real… I mean legal tender recognized by governments as a form of payment for all debts, public charges, taxes and dues. It may not be considered “legal tender,” but Bitcoin is defined as convertible digital currency. It provides a medium of exchange in that it either has an equivalent value in real currency, like the dollar, or it acts as a substitute for real currency.
Regardless of its treatment in other parts of the world, under United State tax law, Bitcoin is treated as property, not currency. This means that the general tax principals applicable to property transactions apply to transactions using Bitcoin.
If you are holding Bitcoin, you need to first determine how you are holding it. Is it investment property? Or is being held as Inventory in a trade or business? If you have ventured into buying Bitcoin, then you are likely holding it as investment property (think stocks or bonds). Let’s take a look at Joe Consumer who buys one Bitcoin at the price of $25 back in 2010. Joe holds onto the Bitcoin for four years. He then sells it in 2014 for $250. Joe will have a long-term capital gain of $225, which will be taxed at Joe Consumer’s applicable capital gains rate rather than his ordinary income tax rate. The gain is considered long-term because Joe held the Bitcoin for more than one year. What if Joe, the Businessman, had purchased the Bitcoin as Inventory for sale to the public in his business? Then Joe, the Businessman, would have realized ordinary gains (or losses), rather capital gains (or losses) once he sold the Bitcoin.
Okay… makes sense, but what if Joe Consumer is not selling his Bitcoin? Instead, he is using his Bitcoin as currency to buy a product. It does not matter. If Joe Consumer uses his Bitcoin that he purchased at $25 in 2010 to buy a widget with a fair market value of $250 in 2014, Joe will still have a capital gain of $225. Likewise, if Joe bought a widget with a fair market value of $10, he will have a capital loss of $15. This is where Bitcoin differs from regular currency. Remember, Bitcoin may be defined as a convertible digital currency, but in the United States it’s taxed like property.