New IRS rules make using Bitcoins a fiasco

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The IRS now forces you to keep a strict record of every Bitcoin purchase made all year long -- a complicated bookkeeping game.

The United States' new Bitcoin tax rules just made casual, everyday use a complicated bookkeeping headache.

The Internal Revenue Service's notice last week will force the average Bitcoin user to keep a strict record of every purchase made all year long -- then perform difficult calculations to account for the changing value of a bitcoin.

It's meant to extract taxes from any gains in Bitcoin's value, and the rule applies to everything bought with electronic money, from coffee to cars.

That's problematic for two reasons. The going rate for a bitcoin fluctuates wildly -- easily by more than $10 a day. And no one diligently records the price of a bitcoin at every purchase.

'That would obviously create an accounting nightmare for taxpayers and may cause taxpayers to avoid using virtual currency,' said Jeffrey Hochberg, a tax attorney in New York.

Related: What is Bitcoin?

In theory, the IRS could chase after anyone who quietly spends bitcoins that are more valuable than when he or she bought them.

For example, you buy a bitcoin for $500. It doubles in value to $1,000. With your more powerful bitcoin, you can now spend it all on a guitar. You enjoyed a $500 gain in Bitcoin value, and you'll need to report that on your tax return.

'It will get complex if you are spending at multiple merchants... over the course of a year,' said Marc Nickel, a Silicon Valley attorney who closely studies Bitcoin.

The complicated rules kick in, because the IRS deemed Bitcoin a property. If it were labeled a currency, users would be able to treat purchases like worry-free transactions made in euros or yen while traveling abroad. That's why the Tax Foundation says the IRS got it wrong, calling the compliance requirements 'inappropriate.'

The United States isn't alone in this approach. Finland applies capital gains taxes on Bitcoin gains, and Ireland is considering something similar.

In reality, though, the IRS will have a difficult time tracking any of this. Bitcoins offer near anonymity, because computerized wallets aren't tied to actual individuals. So, while following the law will be annoyingly difficult, there's little chance of a crackdown on the average Joe.

'Nobody in their right mind would ever comply with that,' said Steven Rosenthal, senior fellow with the Tax Policy Center. 'The IRS can't even get the information they need from normal consumer purchases.'

And, as former IRS commissioner Mark Everson points out, there's a big difference between new IRS rules and how it decides to administer them.

'The service is very much strapped for resources and audits are in decline,' said Everson, who is now a vice chairman of tax consulting firm Alliantgroup.

Alex Daley, a technology investment analyst with Casey Research, said the IRS really is just casting a wide net that lets it hunt down big tax dodgers.

'This ruling is a warning shot across the bow, mostly to business and large traders, that you'll have to deal with the income tax evasion consequences,' Daley said. 'I don't think it's a signal to consumers that we'll take away the anonymous nature of Bitcoin.'

If the federal government wants to keep track of people's bitcoin wallets, it could force online exchanges -- where people buy and sell bitcoins -- to follow tax rules similar to those at brokerages. Those financial institutions must submit information about clientele to the IRS, which keeps track of people's accounts.

Related story: IRS says Bitcoin is taxable

By declaring bitcoins and virtual currencies as property, the latest IRS guidance also opens the door for states and cities to apply sales taxes anytime someone acquires a bitcoin.

And things get trickier for companies that accept bitcoins as payment and keep them for a prolonged period of time. Any drop in Bitcoin value could shrink their revenue but leave them on the hook for a fixed amount in sales taxes.

Nickel hopes a mathematically-talented, smartphone app maker answers the call.

'This is a space where the killer Bitcoin app could emerge,' he said. 'Something that tracks your basis [Bitcoin value] and records gains and losses against market value, daily.'

In the meantime, the IRS is accepting questions about the recent notice by email.