Can crypto be taxed like gold? Is regulation the real threat to bitcoin's $1 trillion market cap?
(Kitco News) As bitcoin continues to surprise with new milestones almost daily, are U.S. officials signaling that more regulation is coming, and is that a threat to this year's massive price rally?
The crypto space has been all the rage so far this year, with bitcoin at its center.
Yet, despite all the good news, there are signs of worry. After surpassing market capitalization of $1 trillion on Friday, bitcoin prices tumbled from new record highs of $58,000 back to $50,000 on Monday. At the time of writing, bitcoin was trading at $54,222.74, down 6.30% on the day.
Weighing on bitcoin were the latest comments from Tesla CEO Elon Musk, stating that prices "seem high" after the digital currency hit the latest new record.
But what about regulation? Could increased scrutiny from the U.S. officials trigger even a bigger selloff?
Recently, Treasury Secretary Janet Yellen has been speaking about the importance of bitcoin regulation while focusing on illicit financing risks. Yellen has also been referring to bitcoin as a very volatile and "highly speculative asset."
"I think it's important to make sure that it is not used as a vehicle for illicit transactions and that there's investor protection. And so regulating institutions that deal in bitcoin, making sure that they adhere to their regulatory responsibilities, I think is certainly important," Yellen told CNBC last week.
Earlier in February, Yellen told the Treasury's innovation policy roundtable that the "misuse" of cryptocurrencies like bitcoin is "a growing problem."
"I see the promise of these new technologies, but I also see the reality: cryptocurrencies have been used to launder the profits of online drug traffickers; they've been a tool to finance terrorism," she said.
The existing oversight over bitcoin is a "patchwork of regulations" that varies from state to state, analysts told Kitco News.
"The way federal regulation usually works is that an agency will be assigned to be your primarily federal regulator. For instance, banks are regulated by the Federal Reserve, brokerages are regulated by the SEC asset managers, and commodities trading firms are regulated by the CFTC. Each one of those touches on bitcoin but doesn't have primarily federal regulatory authority over bitcoin itself," explained Bloomberg Intelligence analyst Ben Elliot.
Here is a quick breakdown:
• Virtual currency spot exchanges are overseen by State Banking regulators via state money transfer laws.
• The U.S. Internal Revenue Service (IRS) treats virtual currencies as property, which is subject to capital gains tax.
• The U.S. Treasury's Financial Crimes Enforcement Network (FinCEN) is in charge of monitoring bitcoin's transfers for anti-money laundering activity.
• The Securities and Exchange Commission (SEC) has taken action against unregistered ICOs (initial coin offerings).
• On the CFTC side, bitcoin has been declared a financial commodity, which means that the CFTC can regulate futures and other derivatives that are settled in bitcoin or are based on bitcoin.
What this reveals is that there is no federal oversight of bitcoin's spot markets. "The companies that allow you to buy and sell bitcoin and then exchange it back into a fiat currency are essentially unregulated," said Elliot. "Their primary regulator is the state they operate, which use their own money-transmitter regulations."
There are currently no federal laws that say bitcoin is subject to regulation and that a specific agency is in charge of regulating it. "The federal government has oversight only to the extent of the Bank Secrecy Act and the Patriot Act and other things that govern 'now your customer,' 'anti-money laundering,' and countering the financing of terrorism," Elliot added.
How is bitcoin taxed?
Important to note that bitcoin is not considered a currency in the U.S. and doesn't have any special tax rules applied to it yet. For tax purposes, the IRS currently treats bitcoin as property and not legal tender.
"If you tried to pay for something with Bitcoin, from a tax perspective, you'd be bartering - exchanging a good for a good. That's like selling your bitcoins for a gain or loss and then using the proceeds for the thing that you're buying," said Andrew Silverman, Bloomberg Intelligence government analyst specializing in tax law. "Your gain on sale is the difference between the price you paid for the bitcoin and for how much you've sold it. Most investors will get capital gains treatment for the sale of Bitcoin. If the investor has held it for longer than one year, the maximum rate is 21% (plus the 3.8% excise tax, as applicable)."
Can bitcoin be taxed like gold?
The big question investors have is if bitcoin continues to trade like "digital gold," will it be taxed like gold as well?
This question is important because gold is taxed at a higher rate in the U.S. since the IRS considers gold and other precious metals as "collectibles."
It all comes down to how one is invested in gold. If an investor owns shares in a mining company, it is the same as buying or selling any other corporate share from a tax-perspective. But if an investor chooses to buy physical or gold-backed ETFs, then the tax implications change quite drastically.
"Buying into a gold ETF is akin to investing in gold itself," said Silverman. "Unlike a corporate share or a bond, for example, an investment in gold itself is taxed as a collectible (like investing in art or furniture), so rather than a top 20% rate, gold is taxed at a top 28% rate. If the investor earns more than 200K (individual return) or 250K (joint return), an excise tax also applies, so the final tax rate is 31.8%."
Another way gold can be taxed is if an investor owns a publicly-traded futures contract, he added. "Futures are so-called '1256 contracts' which means they're taxed once a year regardless of whether they're sold, and they're taxed 60% as long-term capital gains (21%, plus the excise tax as applicable) and 40% as short term capital gains (37%, plus the excise tax)."
What this means for bitcoin is that if the IRS changes its definition in the future, investors could be at risk of facing a higher tax rate.
"Treasury could change its mind and tax Bitcoin like gold (i.e., as a collectible)," noted Silverman. "It could also choose to tax Bitcoin like an investment in a currency which has an entirely different tax regime associated with it (i.e., gains or losses on foreign currency investments are taxed as ordinary income, not capital gains)."
So far, the IRS has not addressed cryptocurrencies in much detail. Most tax experts believe that is because the IRS wants "the most flexibility in applying tax to cryptocurrency," he added.
But there are new bills pending in Congress, which could change some of the current regulations. For example, there is the Virtual Currency Tax Fairness Act (H.R. 5635), which was proposed in January 2020. It would provide an exemption for personal transactions where the capital gains are less than or equal to $200.
What's the next big thing?
It seems like a new and comprehensive bitcoin regulation on the federal level is the next big step for the U.S. government, said Crosby.
"Creating a national standard around the patchwork of these state-by-state agreements is the next obvious step. Many of the exchanges will come under scrutiny," he said.
One pressing factor is exchanges like Coinbase going public soon. "When companies like this enter public markets, various regulators want to have more scrutiny. The first step is national action around regulatory standards for exchanges and brokerages themselves. That may cascade down to individual reporting functions, such as tax rates," Crosby noted.
The most significant regulatory event happening right now is FinCEN pushing new regulations about how existing laws are applied to bitcoin. This would potentially mean that bitcoin exchanges would need to adhere to rules like "know your customer."
"You have to have a state-issued I.D. with a physical name and address associated with each account to ensure that it is not money laundering and doesn't finance terrorism," Elliot explained.
These new proposals, which were put together under the Trump administration, were never finalized and are considered quite punitive.
"Now the Biden administration is rethinking how they want to move forward with that because it would not only require to 'know your customer,' but also their customer's counter-parties. This means if you got bitcoin from Coinbase, for example, they would have to know who you are, where you live, and addresses and names of who you subsequently send that bitcoin to."
Yellen's comments, if they were to lead to additional regulation, would be made through FinCEN, Elliot added.
"What's in the grey zone right now are exchanges where people are buying and selling bitcoin, which are basically not touched by the federal government. This is where you could see someone like Yellen testifying that the Treasury thinks it has a blind spot. That could lead to regulation in the future," Elliot stated. "It could be in the form of extending SEC and CFTC authority to exchanges that trade cryptocurrencies. I think a new regulator is very unlikely."
In order to do that, the U.S. federal government will need to bring actual underlying technology and those spot market places into the regulated sphere. At stake here is blockchain surveillance and the ability to monitor market movements at a broader level.
"What that could mean is having APIs from the exchanges directly to the regulators so they can have a real-time view into the market and look for things like manipulation and other types of market distortions," Elliot explained.
Can bitcoin plummet?
New regulations do not necessarily mean a significant price selloff. It could translate into just the opposite, as more regulation could lead to more acceptance and broader adoption, said Celsius Network CEO Alex Mashinsky.
"On the good side, the drivers for adoption are higher prices and more companies announcing they are buying bitcoin. Regulations are already baked into the price as most people know that more are coming. Unfortunately, bitcoin price is still connected to the stock market, and if the stock market crashes, so will bitcoin," he described.
A light-handed approach could be a massive benefit to the space, Crosby said. "It starts to underline the legitimacy of the market on a national scale. You'll see different types of people getting involved, including more corporate treasuries."
Overregulation, however, is always a threat as it could trigger outflows for the markets, he added. "We saw this with China about three years ago, when China shut off all crypto-brokerages in the region, saying it was a national security threat. They since reversed that decision and became one of the largest markets for bitcoin," Crosby pointed out.
After getting the price outlook right in 2020, Mashinsky's forecast for 2021 remains positive for bitcoin, projecting prices to hit $160,000 first and then close the year below $100,000.
"This year is much more complicated. There is no halving, but there is inflation. Plus, we don't know how many sellers we might have. If no one wants to sell at $50,000, prices will go to $200,000," he stated.
How soon will the U.S. see new bitcoin regulation?
There is 100% certainty that we will see more regulation as more capital accumulates in the bitcoin asset class, said Mashinsky.
"We can read and listen to what Yellen and ECB's Lagarde are saying. They are all talking from the same script. Their concern is that the fiat money will lose its dominant position. While they are printing as fast as they can, they are also trying to convince people that bitcoin is a risky asset that may need to be heavily regulated," he said. "History tells us that people will lose trust in fiat currencies."
Yet, the new national regulation would require a lot of willpower and energy from the Biden Administration, whose priorities lie elsewhere at the moment, analysts told Kitco News.
"It ultimately comes down to what the key priorities of the current administration are. There are way more important issues that will take more of a precedent from financial perspective around the market structure, as well as mechanics behind equity markets," said TradingView general manager Pierce Crosby. "This is very much what SEC is concerned with. Anti-money laundering is important, but it takes a backseat to issues like the retail boom in equities, for example."
The priority is very low for the Biden Administration, especially when compared to other pressing matters like dealing with the pandemic, providing additional stimulus, vaccine rollouts, and the adjustment to the tax code, Elliot said.
"That said, there are a bunch of draft bills in Congress that have been circulating for a couple of years and would address some common problems. They would clarify its tax status, extend regulation to spot markets, clarify how banks interact with crypto assets," he noted.
Also, the significant potential driver of additional legislation was Libra, Facebook's stable coin product, which had dissipated since Facebook stepped back from more ambitious aspects of Libra.
"People were worried that it would change the way people interact with commercial banks and would reduce the Fed's control over monetary policy. That had pretty much gone away now," Elliot said.
Barring a black swan event, like a terrorist attack funded by bitcoin, more crypto regulation would be a low priority for the federal government, he added.
"The problem is that it is a huge lift and takes a lot of work. And until something pushes them to do it, it is not a big concern. If you compare bitcoin's market cap to some of the largest ETFs' market caps, it is still inconsequential. All those incremental changes like taxes are probably like a 2022 thing at best just because the state of the world today is that there are way more pressing priorities."