If I buy a house for Bitcoin directly, do I owe the government taxes in Bitcoin or in fiat? If Sue buys a house for 1 Bitcoin, that is, giving the 1 BTC directly to the person selling the house (no fiat involved), does she have to pay a % of that in Bitcoin to the government, or do they demand a fiat %?
If the latter, since Sue has no money on her bank account, she will face the situation of being unable to pay the taxes.
And to get more fiat money, she would have to sell Bitcoin to get fiat money to pay the first taxes, but then she owes more taxes on that!
Isn't this an impossible, eternal loop? Doesn't it prevent anyone from actually using their Bitcoin unless they also have tons of fiat money saved up which they are comfortable burning away for nothing just to pay taxes on their even more hard-earned Bitcoin?
I am not expert in US law, but I have understading of taxes in my local country and general principles.
In general, transactions and taxes are made in local currency, unless it is external trade, financial (like currency exchange) or other operation allowed by local tax/economic laws. Even if transaction is made in foreign currency, it is treated for tax purposes in local currency (converting foreign currency to local at the day of transaction).
In your example there is 99,99% probability that you will pay taxes in fiat currency after buying home. The exact amount depends on the value of bitcoin in the day of transaction. For example, if you by a house at 1 June for 1 bitcoin in the US, then the price of that home is converted to USD, and that sum is later used in calculating taxes.
However, not all jurisdictions currently allow to contract (setting price) in bitcoin for all assets. For example, in your country you can buy bitcoin at local exchange, but you cannot buy a house with bitcoin. However, you can still write buying agreement quoting local currency, paying in bitcoins and signing additional document with the seller regarding that transaction occured in bitcoin in the amount equivalent to price in local currency (this document is equivalent for bank recepeit for local currency). Still, such agreement may not be recognized by local authorities and declared as void.
Regarding the demand for fiat currency. In your example Sue will have to sell some amount of bitcoin to pay taxes. Unless the tax rate is not 100% (which in nonsense) the loop is not eternal.