One of the main principles of modern currency is that it must be “fungible” to be considered as money, which means that one unit, say a $100 bill, is able to replace or be replaced by any other $100 bill; that the two are, in essence, identical and mutually interchangeable.
Based on that fact, the IRS ruled last week that for tax purposes, Bitcoins, a popular type of “virtual currency,” are not interchangeable and therefore not money, but property. While Bitcoin is used as a form of payment for goods and services, their use can have tax consequences that may result in an unexpected capital gains liability.
According to IRS Notice 2014-21, “general tax principles applicable to property transactions apply to transactions using virtual currency,” which basically means that tax liability depends on the value of the Bitcoin at the time it was purchased vs. its value at the time of redemption.
As an example of why Bitcoins are not considered fungible, say you have two Bitcoins, each of which is valued at $100 today. One was purchased five years ago for $10.00, the other a year ago for $90.00. If you make a $100 purchase and pay for it with the Bitcoin that cost you $90, your capital gain in just $10. However, if you pay for the same product with the Bitcoin that cost you $10, your capital gain is $90, which could appreciably increase your tax liability. The Bitcoins are not identically interchangeable, therefore not fungible.
For more information on the ruling, read IRS Notice 2014-21 – answers to frequently asked questions about “virtual currency.”