Convertible Virtual Currency

What Is Convertible Virtual Currency?

Convertible virtual currency is an unregulated digital currency that can be used as a substitute for real and legally recognized currency even though it does not have the status of legal tender. Convertible digital currencies are easily exchanged for fiat currencies such as dollars via cryptocurrency exchanges.

How Convertible Virtual Currency Works

This can be contrasted with non-convertible currencies (or closed virtual currencies) that are not used in external commerce or directly exchangeable for other currencies, such as virtual currency contained within a video game environment.

Convertible virtual currency is an example of how technological advances are driving disrupting changes in the traditional way of doing things across the globe. This is especially true of the way goods and services are paid for and acquired.

Formal Definitions of Convertible Virtual Currency

Virtual currency is defined by the Financial Crimes Enforcement Network (FinCEN) — a bureau of the U.S. Treasury — as "a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency."

A convertible virtual currency usually has a measurable value in real money, but what makes it convertible lies in its ability to be exchangeable. Not all virtual currency can be exchanged for legal tender; therefore, not all virtual currency is convertible.

The Internal Revenue Service (IRS) defines a convertible virtual currency as a virtual currency that has a value in real currency. That means for the IRS, bitcoin, ether, and the likes are convertible virtual currencies.

Another feature of convertible virtual currencies that makes them similar to state-backed currencies is their tax liability, at least in the U.S. "The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences."

Special Considerations

The nature of convertible virtual currencies makes them susceptible to use as vehicles for money laundering, tax evasion, and terrorist financing. This has led to some countries proposing regulatory measures on how the currencies will be observed and used for tax purposes.

El Salvador became the first country in the world in June 2021 to officially start accepting bitcoin as legal tender.

In the U.S., FinCen guidelines rule that virtual currency that can be exchanged for legally recognized money is property, not money, and will be treated as such. Tax principles that apply to property transactions, therefore, apply to these types of currencies.

A taxpayer who receives bitcoin in exchange for goods and services has to record the fair value of the virtual currency in U.S. dollars as of the date it was received. This value is included in computing the taxpayer’s annual gross income. In addition, a virtual currency used for investing is regarded as a capital asset and is thus subject to tax on its capital gains or losses.

Types of Convertible Virtual Currencies

The most popular form of virtual currency remains bitcoin. Bitcoin runs on a decentralized peer-to-peer network that employs blockchain technology to prevent fraud and control the money supply. By way of contrast, the central banks and treasuries of states (like the United States) control the money supply by printing money and taking it out of circulation, raising and lowering interest rates on borrowing, and prosecuting counterfeiters.

Bitcoin is a convertible virtual currency because it can be exchanged for real money based on its determinable value in the market. The value of a bitcoin in dollars has been exchanged from as low as $13 sometime in 2012 to $36,000 in June 2021. Other popular virtual currencies are ether and Ripple.

Convertible Virtual Currencies Example

Virtual currency can be converted for cash through online exchanges or brokers. Exchanges such as Coinbase and Bitstamp enable users to exchange their bitcoins for their local currency. The bitcoin holder makes a sell order like they would if making a trade with a securities broker. The "sell" order includes the number of bitcoins and the price per coin. The user’s account is credited in the local currency when their order is matched to a corresponding "buy" order.

Bitcoin can also be exchanged for real currency using bitcoin ATMs which are only available in select countries. While the online exchanges may take a couple of days for the euro or dollar to be transferred to a user’s account, bitcoin ATMs take only seconds to complete the transaction.

Convertible virtual currencies can also be centralized. Linden dollars is a centralized virtual currency that is solely used in a virtual world called Second Life. Second Life is a social game with a virtual economy where players buy and sell goods using Linden dollars. Players convert their real money (e.g., euros) into Linden dollars at the game’s official currency exchange site known as LindeX.

Like a traditional exchange platform, market and limit buy and sell orders are conducted among the players. As of June 2021, $319 Linden dollars will buy 1 U.S. dollar. FinCEN recognized Linden dollars as a convertible centralized virtual currency in 2013.