Convertible Virtual Currency: Meaning, Types, and Example

Convertible virtual currency is a digital currency that can be used as a substitute for real and legally recognized currency even though it does not have legal tender status. Convertible digital currencies can be exchanged for fiat currencies on exchanges and used as a store of value or payment method in addition to the uses they were created for.

How Convertible Virtual Currency Works

Convertible virtual currencies and fiat currencies can be exchanged for each other. They tend to have an exchange rate based on supply and demand.

Convertible virtual currencies contrast 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 disruptive 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 one that has a value in real currency. For the IRS, bitcoin, ether, and similar currencies 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 some countries to propose regulatory measures for how currencies will be observed and used for tax purposes.

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.

For example, 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 is also regarded as a capital asset depending on how long it has been held and is thus subject to tax on its capital gains or losses.

So, if you received one bitcoin as payment for services, you'd need to report any income generated from that sale as income that year on your taxes. If you didn't spend that bitcoin for more than one year and its market value increased during that time, you'd also owe capital gains taxes on the gain when you cashed it in.

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.

Bitcoin is a convertible virtual currency because it can be exchanged for real money based on its determinable market value. The value of a Bitcoin in dollars has ranged from as low as a few cents to an all-time high of more than $73,000 in March 2024. Other popular virtual currencies are ether and XRP.

Convertible Virtual Currencies Example

Virtual currency can be converted for cash through online exchanges or brokers. Exchanges such as Coinbase and Bitstamp, which Robinhood announced it would acquire, allow 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.

In some circumstances, closed virtual currencies are considered convertible virtual currencies. Linden dollars is a closed 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 rules about virtual currencies recognized Linden dollars as a convertible virtual currency in 2013.

The Bottom Line

Convertible virtual currencies are digital assets that can be bought with and exchanged for fiat currency. They are generally, but not always, cryptocurrencies or other digital assets with a monetary or market value and can be used as payments for goods and services.

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