NOTE: all my Bitcoin posts can be found here.
Today, the Internal Revenue Service clarified a question that had been weighing on many holders of Bitcoin: how profits in the virtual currency will be taxed. Beyond the tax implications (which I will leave to others), the IRS rule could have a dramatic effect on the (1) adoption and (2) regulation of Bitcoin. Today, I’m going to focus on adoption.
As the Wall Street Journal reported:
The [IRS] said Tuesday that it will treat Bitcoin and other virtual currencies like property, not currency, giving a potential boost to investors but imposing extensive record-keeping rules—and significant taxes—on its use.
I see this as a positive for Bitcoin adoption, if a slight one. But it has the potential to be a huge boon to at least one Bitcoin-related business, Coinbase.
Depending on who you ask, Bitcoin is many things—a long-term investment; a short-term investment; a medium of exchange; an enabler of fraud, criminality, and anarchy; a fast track to utopia. To date, pursuit of all these goals has sped adoption. I’m agnostic on the currency in general but the first three purposes strike me as legitimate in principle (utopia is too, but is implausible).
- For Bitcoin as a long-term investment, today’s clarification may be good news. Uncertainty reigned before and it appears that the alternative Bitcoin holders were facing was 60/40 treatment on currency profits (60% eligible for long-term capital treatment, 40% short-term). Being eligible to treat 100% of your trading profits as long-term capital gains is a win.
- The impact on Bitcoin as a short-term investment seems to be minimal to negative (although short-term holders were not eligible for long-term treatment, they may have been able to benefit from the 60/40 treatment before the rule was clarified).
But I doubt these changes move the needle on Bitcoin as an investment because I doubt many Bitcoin traders are motivated by tax strategies. Touching BTC at all is risky.
Of the three legitimate uses of Bitcoin I mention above, the IRS rule may have the biggest impact on Bitcoin as a medium of exchange. The effect here is indirect, but powerful.
The rule makes clear that the use of Bitcoin in retail transactions will result in a taxable event.Thus, currency gains from the transaction will need to be reported as income. A big pain—in theory. Even if the amounts in question are small, records will need to be kept. Many individuals may not bother with it (and may not get caught), but merchants accepting Bitcoin as payment will care. Will this paperwork requirement slow the stampede towards accepting Bitcoin as a method of payment?
Enter Coinbase, to me the biggest winner of this new IRS rule. (I have no Bitcoin or Coinbase holdings.) Coinbase is a platform for buying and selling Bitcoin, but is best known for offering merchants a mechanism to accept Bitcoin as payments without exposing themselves to exchange-rate risk. Bitcoin is a very volatile currency, and many merchants want to accept it—not necessarily because they want to become Bitcoin investors themselves, but to trade on its popularity indirectly. The merchant dream is to bring in these tech-savvy, image-conscious customers, who presumably skew wealthy, and get a bunch of free media exposure for accepting payments in Bitcoin—all without actually holding Bitcoin.
Holding a foreign or virtual currency exposes a merchant to exchange-rate risk—here, the risk that the value of Bitcoin in dollars will fall after the transaction is complete. Coinbase allows merchants to accept Bitcoin without this risk, in exchange for taking 1% of the transaction.
To illustrate: imagine a pair of skis costs $600, which is about 1 Bitcoin at current rates. The customer funds a Bitcoin account (“wallet”) with Coinbase, sends 1 Bitcoin to the ski shop, and the ski shop owner converts the Bitcoin to $594 U.S. dollars (or the equivalent in another major currency). Voila.
For most merchants, this is a triple win: a merchant can appeal to well-heeled customers, get a 1/2 or 1/3 discount on credit card processing fees, and, if she chooses, even direct a percentage of her customer’s Bitcoin payments into her own Bitcoin wallet while converting the rest into a mainstream currency. For merchants with a lot of foreign customers, there’s the added benefit of avoiding currency conversion fees on top of credit card fees.
And after today, there’s a new major advantage to Coinbase: recordkeeping. Coinbase makes it easy to track your Bitcoin transactions—and the amount of money you’ve made by holding Bitcoins over a given period of time, if you elect that option. This was an administrative benefit before the new IRS rule, of course. But now that the IRS has clarified that gains on Bitcoin transactions are taxable from the time of sale, it will be very hard for a merchant to argue that it didn’t know or simply did not keep track of the dollar value of its Bitcoin transactions at the time of the transaction.
In principle, any company that processes Bitcoin conversions like Coinbase benefits from enhanced recordkeeping requirements. But in practice converting currencies to Bitcoin requires success in areas—payment systems, fast technology, cybersecurity, and credibility with customers, merchants, and authorities—where network effects and reliability probably matter a great deal, and Coinbase is regarded as the best right now.
That in itself is a powerful commentary. Just six months ago, an anonymous Redditor copped to manipulating Coinbase’s exchange price. Coinbase appears to have fixed that problem, but on top of all its other problems the market for Bitcoin remains highly illiquid and therefore relatively easy to manipulate. So as always, buyer beware—but at least now everyone will have better records for Uncle Sam.