Bitcoin's original purpose was to act as an alternative monetary system to anyone who wanted to escape the constraints of fiat. More than a decade later, we have reached a point at which cryptocurrency and fiat are inexorably intertwined thanks to the need for on ramps. The relationship between the two has led to inevitable questions of taxation. Should governments tax cryptocurrency assets and profits?

It is a tough question to answer when you look at all the details. On the one hand, cryptocurrency purists would like to see governments keep their hands out of the crypto pie entirely. They are against taxes across the board. On the other hand, there is no denying the fact that lots of people have been made rich by investing in Bitcoin and a couple of its closest competitors. Shouldn't they be taxed on their profits?

In this post we will look at a tale of two taxing authorities: the U.S. and Portugal. The two countries take directly opposite views toward cryptocurrency and taxation. The U.S. is for taxes while Portugal is not. Their positions will undoubtedly play some role in cryptocurrency investments moving forward.

Cryptocurrency in the U.S.

The first thing to note about U.S. cryptocurrency regulations is that they are terribly fractured. The American system calls for the separation of powers as much as possible, so cryptocurrency isn't regulated by just one government agency. It is regulated by multiple agencies including the IRS, FTC, and SEC.

The IRS maintains control as far as taxes are concerned. For their purposes, cryptocurrencies are securities along the same lines as stocks, bonds, and commodities. They are taxed just like securities as well. Taxpayers pay nothing more than income tax on the fiat they use to purchase crypto assets. As for their profits, they pay capital gains on them.

Purchase a single bitcoin at $10,000 and you only pay income tax on that amount if you earned it in the same year you bought the coin. If that coin is worth $11,000 at the end of the year, you have made a $1,000 profit. You pay capital gains tax on that amount.

The short-term investment question

Where taxation on cryptocurrency assets gets tricky is in relation to short-term investments. By rule, traditional securities regulated by the SEC are subject to regular income tax - instead of capital gains tax - if investors do not hold onto them for long enough period of time. Think day traders here.

Day traders buy and sell stocks on a daily basis. These are considered short-term investments by the SEC. They are taxed differently because the IRS does not see them as investments at all. Any profits earned on a short-term investment are considered regular income by the IRS and taxed accordingly.

Here's the problem: the SEC doesn't look at cryptocurrency assets as being equal to traditional securities. In fact, they haven't come up with any definitive classification. So you can buy and sell crypto assets on a daily basis and not be subject to income tax on your profits. Regardless of how long you hold an asset, your profits are only subject to capital gains tax.

Increased enforcement efforts

We conclude the discussion of U.S. taxation by reminding readers that the government recently stepped up its enforcement efforts. Earlier this year, the IRS began sending warning letters to taxpayers they believe had failed to report digital asset profits for the previous tax year.

There are three variations of the IRS letter. The first variation alleges purposeful noncompliance which is akin to tax evasion. The second variation says noncompliance is suspected but it is probably a result of ignorance. The third variation simply recognizes that the taxpayer is believed to own cryptocurrency. It includes a gentle reminder to report profits at the end of the year.

Taxpayers who receive such letters should not ignore them. The IRS has demonstrated it intends to go after cryptocurrency tax cheats aggressively. It would be in the best interests of non-compliant taxpayers to amend their tax filings and pay up. The alternative - being prosecuted and convicted of tax evasion - can bring financial ruin.

Cryptocurrency in Portugal

Cryptocurrency investors in Portugal enjoy a much better situation. Until recently, it was just assumed that Portuguese cryptocurrency owners didn't have to pay taxes on their trades. Now it is official. The Portuguese Tax & Customs Authority just announced in mid-September (2019) that all cryptocurrency trades are tax-free.

The recent announcement backs up somewhat vague statements in a 2016 government document that stated buying or selling cryptocurrency is not considered a taxable event. The phrase 'taxable event' caused some confusion. However, that confusion has since been erased. The government has plainly and simply stated the cryptocurrency trades (buying or selling assets) are not subject to either capital gains or value added tax (VAT).

One obvious exception is receiving cryptocurrency as payment for goods or services. In such cases, the crypto in question is considered income and taxed accordingly. This is true even of companies whose main business activity is in some way related to cryptocurrency. That company's crypto assets are not subject to capital gains or VAT, but any crypto income is subject to appropriate taxes just as if it were fiat.

Crypto is a form of currency

Portugal's position on taxes and cryptocurrency is far more important than just the taxation itself. Here's why: Portuguese law also does not allow for the taxation of profits earned through buying and selling fiat currencies. If you were a Forex trader in Portugal, your currency trades would not be subject to either capital gains or VAT. You would only pay income tax on your regular income.

By treating cryptocurrency the same way, the Portuguese government is essentially acknowledging it as a form of currency. This is big. Government leaders are not just recognizing it as an alternative payment system, they are giving it legitimacy as an alternative currency.

Now, before you get excited, this does not mean cryptocurrency is considered legal tender in Portugal. It is not. Fiat remains the only legal tender in all but two countries in the world, Portugal included. Still, regulators recognizing cryptocurrency as a form of currency is a big step forward.

Capital gains a better way to go

Portugal is the exception to the rule when it comes to cryptocurrency taxation. Nearly every other country in the developed world taxes crypto assets in one way or another. That may not be your cup of tea, but it is what it is. So with that understanding, let us talk about the best way to tax crypto assets from the taxpayer's perspective.

The U.S., UK, and many other countries draw a distinct difference between regular income and investment income. We will use the U.S. as an example. Regular income in the U.S. is income earned by working a job or engaging in a hobby for which you get paid. Gambling winnings are also considered regular income.

Investment income is money earned on investments. These include typical investments like stocks, bonds, and government securities. But it doesn't stop there. If you sell your home for profit, said profit is considered investment income. The same is true if you flip houses for a living.

Regular income is taxed at one rate while investment income is taxed at another. It is the difference between income tax and capital gains tax. The U.S., like most other countries with similar systems, charges capital gains at a lower rate. The other thing to realize is that capital gains taxes are assessed at a flat rate whereas income tax in the U.S. is progressive. The more income you earn, the higher your tax rate.

Based on this sort of system, capital gains is the better way to go if you're intent on taxing cryptocurrency assets. Capital gains taxes tend to be cheaper in most countries. They are also subject to fewer regulatory concerns, so there is a lot less paperwork involved. On the other hand, income taxes can be a complicated nightmare.

Future cryptocurrency taxation

Portugal and the U.S. could not be more opposed in their approaches to cryptocurrency taxation. Portugal takes a completely hands-off approach while the U.S. is looking to tax crypto assets as much as possible. What does that say about the future?

Unfortunately, more countries are likely to adopt the U.S. approach over Portugal's approach. The uncomfortable truth is that governments have an insatiable appetite for revenue. The more revenue they collect, the more they can spend. Cryptocurrency assets represent just another way to increase revenue.

No one should be surprised if U.S. regulators get their acts together and come up with a unified policy for taxation. Likewise, do not be surprised if the EU eventually goes into aggressive taxation mode. It is probably only a matter of time before Portugal falls as well. For now, crypto assets there can be bought and sold tax-free. But the chances of that remaining intact 50 years from now are slim.

If nothing else, Portuguese investors would do well to make as much as they can on crypto trades while they can do it tax-free. Should there ever come a point at which the government changes its mind, investing in cryptocurrency will not be nearly as attractive as it is today.