Copyright John T. Reed 2013

I read that a guy who had $6.5 million in bitcoins threw away his hard drive and subsequently learned that doing so meant he could no longer use his bitcoins and therefore no longer owned them.

Do I believe that story? No. I think it’s an urban legend. But then I think the whole idea of bitcoins is akin to an urban legend.

The main question it raises for me is are bitcoins really so devoid of any physical presence?

I wrote about the Amex TV commercial where a guy washes ashore wearing nothing but tattered pants and shirt. But those shorts contain his Amex card. Using only that card he buys nice clothes, haircut, great meal, a spectacular hotel room, and ends up climbing into a private jet. Here it is:

What, pray tell, is the bitcoin equivalent of that Amex card?

Can you wash up on shore with just your bitcoin password? Do you have to have an IP address and if so what proves that you have it?

What about your computer that you used to acquire your bitcoins being stolen? Or getting a virus? Or falling off the table and breaking? Or being hacked? Cash can be damaged or stolen or lost by accident. Can bitcoins? If not, why not? If you have $6.5 million in bitcoins, some physical thing has to be safeguarded to prevent them from being lost, stolen, or destroyed. What is it?

My first car had an 8-track tape player in 1968. We also have lots of VHS tapes of movies. My first computer in 1980 was a TRS-80 with floppy disk drives.

No doubt, today’s technology will someday be as obsolete as those technologies. And it will happen sooner than those became obsolete because the rate of change is accelerating. So how do you prevent your $6.5 million of bitcoins from going the way of your 8-track tapes or your TRS-80?

There are times when your assets are the business of third parties. For example, when you seek credit, you must your assets, liabilities and income, and prove them. How, pray tell, do you prove to the lender or employer that you have those bitcoins.

If you used to have bitcoins, but sold them, how do you prove to, say, your wife who has filed for divorce that you no longer have them? If you used to have bitcoins, but no longer do, and declare bankruptcy, how do you prove you no longer own them?

Let’s get to tax law. In tax law, the IRS can allege that you had a certain amount of income and demand overdue but unpaid tax on it. The burden of proof is then on you to prove that you did not have that income. How do you prove you did not receive income and convert it to bitcoin?

The 12/21/13 Wall Street Journal had a very good article on the U.S. income tax ramifications of bitcoins.

They obviously are not mentioned in the Internal Revenue Code or any Treasury regulation or IRS ruling. So how will they be treated by the IRS and U.S. courts?

The Journal said bitcoins might be:

• a commodity

• a currency

• a capital asset

• using bitcoins to buy or sell non-bitcoins may be a barter transaction

Each is taxed differently.

I am the author of Aggressive Tax Avoidance for Real Estate Investors, now in its 19th edition. I have sold over 100,000 copies of that book. Based on my knowledge in that book I would ask these additional questions:

• Can you do a tax-free exchange under IRC §1031? In other words, are bitcoins “like kind” to another kind of asset or are they one of the excluded types of assets, namely securities, foreign for U.S. or vice versa, personal property, inventory, bond, stock, an interest in a partnership, a certificate of trust, a chose in action?

• What is the definition of tax negligence with regard to bitcoins?

• What is the definition of tax fraud with regard to bitcoins?

• With regard to bitcoins, what are the valuation definitions of “reasonable basis,” “reasonable cause,” “substantial authority,” “adequate disclosure?”

• What will the incidence of audit be for transactions where the IRS knows or suspects bitcoins were involved? They could place emphasis on them and audit a much higher percentage of them.

Who, pray tell, should you use as your CPA and tax lawyer? In other words, who is a good tax advisor to use for bit coin matters? The answer is no one because they are not only new, their very tax nature is unknown.

• In the event of losses, can they be deducted from passive income?

• How many different ways may you take title to bitcoins under your state law? (e.g., community property, joint tenants, tenants in common, S corporations, LLCs, etc.)

• How much were your bitcoins worth in USD when you bought them? When you sold them? Who says so?

• If bitcoins are a currency, are they your “functional” currency or a foreign currency? It makes all the difference.

• If you need an expert to appraise and/or testify as to value, who might that be and what are his qualifications to be presented to the judge?

• What is your basis in the bitcoins? If you buy them? If you trade for them? If you inherit them? If they are given to you as a gift?

If you buy or sell something with bitcoins, it may be considered barter. If it is barter, the question is what was the USD value of that you gave up and the USD value of what you received. The answer to that may mean you had a taxable gain or a taxable loss. Is the loss personal and therefore not deductible like gambling losses? Is it capital which is taxed at 15% or 20% or is it ordinary income which is taxed as high as 39.6%.

The Journal wonders whether your bitcoins are a “foreign financial account” for the purposes of reporting to the Treasury on the FBAR form and/or to the IRS under From 8938. No taxes are dues but there are severe penalties if you fail to make those reports complete. And I wonder how you fill out the forms if they are required. They ask for the name and address of the foreign account, the account number, the peak USD value of the account during the year.

The IRS and the Justice Department are required to prevent tax evasion and money laundering. That gives them the right and authority to require you to prove you are not doing either. How are you going to do that with bitcoins?

The Journal quotes Jonathan Horn, a certified public accountant in New York as saying

If you take a reasonable position, the [IRS] will probably accept it.

I know of no basis for his saying that. No statute. No regulation. No IRS rule. No case law. I can point to a number of situations where the IRS acted like they were on commission and chose the interpretation least favorable to the taxpayer. Indeed, one could argue that IRS’s reason for existence is to collect based on the interpretation that generates the most revenue. The R in IRS stands for “revenue,” not “reasonable.”

It may be that the most favorable interpretation makes the transaction worth doing but the least favorable interpretation is a deal killer. If you don’t know which you are going to get, I do not see how you can get involved with bitcoins until the IRS or Congress clarifies the situation. In view of all the hostility to bitcoins, I would expect the Congress and the IRS will go for the least-favorable-to-the-bitcoin-taxpayer approach.

It may be that this is above the pay grade of IRS or Treasury. It may be that the President and/or Congress will by executive order or statute totally outlaw all possession or use by U.S. residents of bitcoins. A sort of capital control but only applicable to one type of “currency.”

My advice, if I were allowed to give such advice, would be to report the most-favorable-to-you method but assume they will come in later and apply the least-favorable-to-you interpretation and make sure you set aside the money to pay that least favorable to you interpretation if it goes that way.

John T. Reed