...The IRS’s characterization of Bitcoin as “property” may have indirectly made it more difficult for the average retail investor that primarily invests through mutual funds to gain exposure to Bitcoin. The tax rules currently permit mutual funds to invest in “foreign currency” but would likely prohibit an investment in the newly launched Bitcoin investment vehicles because the underlying asset is not “foreign currency.”
The digital currency Bitcoin has recently gained the attention of the general public and the media primarily because of its meteoric rise in value. As a result government regulators have also started to focus their 
attention on these digital currencies. To the displeasure of some users of these digital currencies, the Internal Revenue Service recently announced that such “virtual currencies” are fully subject to U.S. federal income taxation. The IRS’s notice reminds taxpayers who may have falsely believed that they could escape taxation on their Bitcoin transactions that they may be subject to penalties for failing to comply with the U.S. tax laws as they relate to Bitcoin. For example, the IRS explained that depending upon the scenario in which a taxpayer uses Bitcoin, it may also be taxed as wages, subject to the self-employment tax, subject to withholding, and subject to the information reporting rules.
The most significant aspect to the IRS’s notice was that the IRS announced that they intend to tax virtual currencies as “property” rather than as “foreign currency.” The IRS’s position may be significant depending 
upon how a user interacts with Bitcoin. Whether a taxpayer is considered a “miner,” a merchant, an investor, a trader, or a dealer in Bitcoin, the “property” characterization affects how the user is taxed.
For example, the “miners” of Bitcoin who generate new Bitcoins through the use of sophisticated computers may be considered to be engaged in a trade or business to produce the “property” rather than simply participating in a hobby. Such a characterization could affect whether the “miner” is entitled to take certain business deductions or capitalize their expenses, pay self-employment taxes, and potentially affect the character of any gains or losses with respect to the Bitcoins received from the mining activity. For investors, the characterization of Bitcoin as “property” likely means that they will hold Bitcoins as capital assets and any gain or loss will be subject to capital gains taxation. Investors, however, will unfortunately be subject to limits on itemized deductions and investment interest deductions from their Bitcoin investments.
The IRS’s notice also indicates that all taxpayers that interact with Bitcoin will be subject to complex cost basis tracking.
Because Bitcoin is fungible and greatly fluctuates in value on a daily basis, Bitcoin users will need to track their cost basis for each Bitcoin obtained and determine whether they have gain or loss on the subsequent exchange of the “virtual currency.” The IRS’s characterization of Bitcoin as “property” may have also indirectly made it more difficult for the average retail investor that primarily invests through mutual funds to gain exposure to Bitcoin. The tax rules currently permit mutual funds to invest in “foreign currency” but would likely prohibit an investment in the newly launched Bitcoin investment vehicles because the underlying asset is not “foreign currency.”
The IRS’s recent announcement is a step in the right direction and provides some needed clarity to a murky area of the tax law. Many challenges, however, remain for users of Bitcoin in complying with their federal tax obligations.
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[Richard C. LaFalce is an associate in Morgan, Lewis & Bockius LLP’s Tax Practice. He focuses his practice on the creation and taxation of private and pooled investment vehicles, including mutual funds, REITs, hedge funds, and other investment related entities.]
