The IRS just published Notice 2014-21 which explains the IRS’ vision on how general tax principals apply to “virtual currency” transactions like Bitcoin.

If you’re not familiar with Bitcoin, it’s a currency that isn’t issued by a central government. And just to be clear, there isn’t an actual “coin” associated with it either. The currency is created by very powerful computers.

Ok, back to the IRS news. While this is just the IRS’ interpretation of the law – failure to follow it could result in penalties if your contrary opinion ends up being wrong.

The jist of the Notice is that Bitcoin is a capital asset and not currency.

Here is a simple example:

Day One: You purchase one Bitcoin for $600

Day Two: On day two your Bitcoin increased in value to $650.  You then decide to use your Bitcoin to purchase a flight to Europe.

If you would have used cash this would not be a taxable event.  But under the IRS’ ruling you now have a short-term capital gain of $50 ($650 amount realized less your cost basis of $600).  You will also have to send a check to the IRS for about $20 if you are in the highest tax bracket.

Bitcoin will certainly complicate your taxes and cause you to have to keep careful records.

From a policy standpoint, the government thinks that Bitcoin is a favorite tool for tax evasion and other illegal activities (and they are probably right).  This Notice is a clear disincentive from the government to use Bitcoin.