Virtual currency bitcoin has been recognized by the German Finance Ministry as a "unit of account", meaning it is can be used for tax and trading purposes in the country.
Bitcoin is not classified as e-money or a foreign currency, the Finance Ministry said in a statement, but is rather a financial instrument under German banking rules. It is more akin to "private money" that can be used in "multilateral clearing circles", the Ministry said.
"We should have competition in the production of money. I have long been a proponent of Friedrich August von Hayek scheme to denationalize money. Bitcoins are a first step in this direction,"said Frank Schaeffler, a member of the German parliament's Finance Committee, who has pushed for legal classification of bitcoins.
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Bitcoin is a virtual currency that allows users to exchange online credits for goods and services. While there is no central bank that issues them, bitcoins can be created online by using a computer to complete difficult tasks, a process known as mining. Currently one bitcoin is worth just over $119.
Schaeffler said the new ruling showed German authorities were preparing regulations on how to tax bitcoin transactions. According to German newspaper Die Welt, the government has stated that the legal classification of bitcoin means that commercial profits that stem from using the currency may be taxable.
Kathleen Brooks, a research director at FOREX.com, told CNBC that classification by the German government gave bitcoin legitimacy to be used as a settlement currency in one of the world's largest economies. She said this was a big step forward for the bitcoin movement.
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"I think it is interesting that Germany has gone ahead and given legal status to the bitcoin, as it could become an alternative to the euro if the single currency ever ceased to exist," Brooks said. "If the euro does go belly up the German authorities could potentially still collect tax if everyone started using the bitcoin - that's a good example of German forward-thinking!"
Success for bitcoin rests on regulatory fair-treatment and the existence of a level playing field with other currencies, said, Schaeffler. He added that it would be bad if national authorities smeared bitcoin as a criminal tool for money laundering, just because it makes anonymous transaction possible.
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"Sooner or later, depending on the success of private currencies, authorities will feel the urge to ban or regulate private currency. A free country should resist and not intervene in citizen's private choice of money. In my opinion the production of money is none of the government's business," Schaeffler said.
Bitcoin regulation has been a hot topic in the last couple months. The New York Department of Financial Services issued subpoenas last week to several companies associated with bitcoin, as part of an inquiry into the business practices of the industry, and both the Federal Bureau of Investigation (FBI) and the Department of Homeland Security (DHS) are investigating the currency.
In addition, Thailand moved to ban the digital currency in July,according to Bitcoin Co., a Bangkok-based website that trades the digital currency. Bitcoin Co. said it was prevented from registering with Thai governmental agencies, which would have allowed people to legitimately use bitcoin.
Correction: an earlier version of this story incorrectly stated that bitcoin was legal tender. The virtual currency has been confirmed as a financial instrument or "private money".