With the legislative approval of bitcoin as legal tender in El Salvador, United States (US) taxpayers should be mindful of certain Internal Revenue Code1 (IRC) provisions that could be triggered if more countries decide to adopt bitcoin as legal tender.
On 8 June 2021, El Salvador’s Legislative Assembly approved legislation to adopt bitcoin as legal tender in the country. Under the key provisions of the approved bill, businesses and lenders would be required to accept bitcoin as payment for any monetary obligation. Taxpayers could make tax remittances to the Government in cryptocurrency.
The possible adoption of bitcoin as legal tender by El Salvador prompts several questions for US taxpayers holding the cryptocurrency, particularly around income and loss characterization.
IRS’s current position
Under Notice 2014-21 and the October 2019 Frequently Asked Questions published by the Internal Revenue Service (IRS), cryptocurrency is generally considered “virtual currency” and treated as property. Tax principles related to property transactions apply to transactions involving cryptocurrency. To the extent that bitcoin is held for investment purposes, it is generally treated as a capital asset, and any resulting gains and losses are characterized as capital.
Bitcoin adoption as legal tender
If more countries adopt bitcoin as legal tender, the US federal income tax treatment of bitcoin could change. Instead of being treated as an investment that is a capital asset, bitcoin could be treated as generating ordinary income under Section 988.
Section 988 treats as ordinary income exchange gains or losses arising from transactions that are denominated in a currency other than the taxpayer’s functional currency or that are determined by reference to the value of one or more nonfunctional currencies. For US taxpayers that hold bitcoin for a long time and have a low-cost basis in the assets, ordinary income treatment on the sale of those assets could prove costly.
If bitcoin were adopted as legal tender, forward transactions in bitcoin could be deemed “IRC Section 1256 contracts.” Section 1256 requires gains or losses from “IRC Section 1256 contracts” to be marked to market annually, as if those contracts were sold on the last day of the tax year. The statute defines “IRC Section 1256 contracts” as “any foreign currency contract.” Under Section 1256(a)(3), gain or loss on the deemed sale of the contract is treated as 60% long-term capital gain and 40% short-term capital gain (60/40 treatment). Under Section 1256(f)(2), however, 60/40 treatment does not apply to any gain or loss that would otherwise be ordinary (e.g., Section 988 gain or loss).
The IRS has not changed its current position on bitcoin. Without further guidance from the IRS on what is considered a nonfunctional currency, it is unclear whether Sections 988 and 1256 would apply if bitcoin is treated as currency. Given the possible new legal tender status of bitcoin in El Salvador, taxpayers should be aware of the potential tax implications for bitcoin transactions in the United States and the uncertainties that still exist under IRS guidance.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), Financial Services Office
- Thomas Shea, San Francisco
- Jonathan Jackel, Washington, DC
- Navin Sethi, San Francisco
Ernst & Young LLP (United States), International Tax and Transaction Services Capital Markets
- Matthew Stevens, Washington, DC
- Lee Holt, New York
For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.
- All “Section” references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.