The taxman is watching you. Photographer: Brent Lewin/Bloomberg
The taxman is watching you. Photographer: Brent Lewin/Bloomberg

Longtime readers know that I'm a bitcoin skeptic. Even if bitcoin meets the fondest hopes and dreams of its early adopters, governments are likely to make it unviable as a currency.

Even if the government isn't directly trying to shut bitcoin down, its actions can make it harder for the virtual currency to survive.

Case in point: The Internal Revenue Service has just ruled that bitcoins are assets, subject to capital-gains tax when they're sold. Among other things, that means that you -- or your bitcoin exchange -- will need to track the price at which each one is acquired, and the price at which you sell it, and pay capital-gains tax on the difference.

Now, maybe you'll say that you have no intention of doing any such thing; you're going to keep your transactions off the books. And true, there is no way to force you to move your bitcoins off a personal computer and onto a U.S.-based exchange. But the government can prevent most merchants from accepting bitcoins unless they come from an exchange that issues tax returns. They can also keep exchanges that don't issue tax returns from doing business with legitimate financial institutions. You start having to engage in rather elaborate money-laundering operations in order to turn your bitcoins into easily available cash. And if you do get caught, bitcoin's public blockchain will provide law enforcement with a nice ledger of all your illegal activity, the better to subject you to stiff penalties for tax evasion.

The government isn't doing this because it hates bitcoin; it's doing it because whenever there is a financial gain, the IRS is in the business of analyzing it, categorizing it and making sure that the government gets its cut. If the IRS had ruled that bitcoin was a currency instead, it would have alleviated some of the these problems, but created others, because gains and losses from currency transactions are also what's known as a "taxable event." A different ruling would simply have meant slightly different rules about tax treatment.

Even though the government isn't actually trying to quash the use of bitcoins, you can see how this might sharply limit their usefulness in the normal economy. There's a reason that most U.S. merchants do business in dollars rather than euros or gold; people don't like taking on currency risk unless they have to, and a currency in which you have to track each individual unit is likely to be more trouble than it's worth.

Is it possible to keep your activity under the wire so that it never attracts the attention of law enforcement? Sure: There are undoubtedly even now people making substantial tax-free incomes off of trading collectible game cards or what have you. But these markets survive precisely because they're small relative to the economy; it's hard to make a substantial tax-free income trading oil futures. Which brings us back to my original point: Bitcoin is only safe from the government as long as it remains essentially a hobby, rather than a meaningful alternative to the U.S. dollar.

To contact the author of this post: Megan McArdle at mmcardle3@bloomberg.net.

To contact the editor responsible for this post: Timothy Lavin at tlavin1@bloomberg.net.