In the coming weeks we plan to release a series of articles examining the positions the IRS has taken related to virtual currencies. While the IRS’ view is still evolving on certain virtual currency issues and it has yet to fully address some of the more complex questions, the basics are clear. In Part One of this series we are going to discuss what the IRS views as virtual currency, how virtual currency is treated for Federal income tax purposes, and what constitutes cryptocurrency.
What is virtual currency?
According to the IRS, a virtual currency is a convertible digital representation of value that functions as a unit of account, a store of value, and a medium of exchange. The IRS makes it clear that the definition of virtual currency does not refer to the U.S. dollar or a foreign currency which the IRS refers to as real currency.
The IRS definition can be broken into three parts. First, a virtual currency has a digital representation of value. Virtual currency is exclusively issued in the form of an electronic representation. There is no such thing as a physical asset to prove you hold virtual currency. The first criteria for virtual currency is well understood and, at least up to this point, seldomly needs to be debated.
Importantly, when the IRS references virtual currency, it implies the word “convertible”. This means that the virtual currency must have an equivalent value in real currency or act as a substitute for real currency. As a result of convertibility being implicit in the virtual currency definition, certain types of gaming currency and things such as frequent flier miles do not come under the IRS’ definition of virtual currency.
The final element of the virtual currency definition requires it to function as a unit of account, a store of value, and a medium of exchange. These three criteria are universally accepted as three of the necessary functions for an item to serve as money. As a result of these three characteristics being incorporated into the virtual currency definition, it is worthwhile to examine each function briefly.
Unit of Account – A unit of account is a function that allows the currency to value goods and services, record debts and liabilities, and make calculations based on a standard numerical unit of measurement. Furthermore, for a currency to meet the unit of account criteria, it must be divisible into smaller units without losing value. Additionally, each unit of the currency must be perceived as equivalent to an identical unit (i.e. fungibility). Finally, the specific size or weight of the unit must be verifiable.
Store of Value – A store of value is a function of currency that means it can be saved, retrieved, and exchanged at a later time. A good store of value is durable which is ubiquitously found in virtual currency given its digital format. While virtual currency can be lost due to user error, it does not erode due to elements or time.
Medium of Exchange – A medium of exchange is a function of currency that means it is widely accepted and therefore can be used as an instrument to facilitate the sale, purchase, and trade of goods between various parties. As a result of the currency being able to be exchanged for any good, the medium of exchange function extinguishes the need for parties to barter their goods between each other.
Finally, the IRS has taken a broad approach in identifying virtual currency so long as it is convertible. The IRS states that if a particular asset has the characteristics of virtual currency, it will be treated as a virtual currency regardless of how the taxpayer may label the instrument.
How is virtual currency treated for Federal income tax purposes?
Virtual currency is treated as property and the general tax principles applicable to property tax transactions apply to transactions using virtual currency. This is good news as there are numerous general tax principles that can be applied to virtual currency. This makes basic transactions involving virtual currency easy to understand based on IRS rules, regulations, and precedent involving other property transactions. We will explore some of these basic virtual currency property transactions in future publications in this series.
What is cryptocurrency?
Cryptocurrency is a subset of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger. If the transaction of a cryptocurrency is recorded on a distributed ledger, the transaction is referred to as on-chain. If the transaction of a cryptocurrency is not recorded on a distributed ledger, it is referred to as off-chain (i.e. the lightening network).
With these most basic questions examined we are going to start discussing some of the more tax centric questions discussed in the FAQ. Our next publication will explore the concept of cost basis.
