The most important thing for crypto investors to realize is that while Bitcoin is considered by its proponents to be the first form of decentralized currency, the IRS treats it as property, not as currency. As a result, Bitcoin transactions may be subject to capital gains tax.
Put simply, the IRS believes that virtual currency is an exchange medium that, because it has no legal tender status anywhere in the world, is only acting as a substitute for real currency. In legal terms, Bitcoin is considered a “convertible virtual currency” that can be purchased or sold in exchange for fiat currency. Smart investors who want to minimize their taxes can read on to find out about tax implications of Bitcoin trading, compliance requirements, taxable events, common mistakes, and more.
Tax Implications of Viewing Bitcoins as Property
It may seem like the distinction between how the IRS views Bitcoin trading and how actual investors conceive of their transactions is minor, but it has major tax implications. When a consumer trades in his or her Bitcoin for fiat currency, for example, this is considered a capital gain for tax purposes. In the eyes of the IRS, that consumer is selling a piece of property and receiving taxable income in return.
When a consumer spends his or her Bitcoins or altcoins, the IRS views it as two separate but related transactions. One involves the disposal of the virtual currency, while the other covers the consumer’s spending of the equivalent monetary amount in fiat currency. This may sound complicated, but it is the easiest way for the IRS to ensure that virtual currency transactions occurring within its jurisdiction are being taxed appropriately.
Any consumer who receives a payment in Bitcoins or other virtual currencies for either material goods or services provided has to report that payment when it is received. He or she should compute the fair market value of the virtual currency received on the date of the transaction, convert it into U.S. dollars, and report it as income on the year’s tax return.
Bitcoins that have been obtained through purchase don’t need to be reported until they are sold. In these circumstances, taxpayers don’t have to report and pay income taxes on 100% of the money they get from selling their Bitcoins. Instead, they pay taxes only on the amount of income realized through capital gains or, in plain English, the difference between how much the Bitcoins were worth when they were purchased and how much more they were worth when the taxpayer sold them.
The IRS and BTC Portfolios
Bitcoins that are being held as capital assets in BTC portfolios are treated as property. That means Bitcoin transactions must only be reported to the IRS as income when they involve capital gains. In other words, it is perfectly legal for consumers to buy Bitcoins and hold onto them in a BTC portfolio for as long as they want without paying taxes on them until they are eventually transferred.
The amount of time that the Bitcoins are held in a consumer or investor’s wallet will impact how they are taxed upon being sold, though. When Bitcoins are held in a consumer’s virtual wallet for less than a year before being sold, they are taxed as ordinary income.
When a taxpayer sells his or her Bitcoins more than a year after buying them, they are taxed at a different rate of either 0, 15, or 20 percent. The amount of Bitcoin taxes consumers have to pay on Bitcoins sold after a long-term holding period will depend not on the amount of capital gain realized through the sale but on his or her overall income.
There are several different types of taxable events involving Bitcoin transactions. The first has already been described in detail above. It consists of the straightforward sale of Bitcoins that had previously been purchased with fiat currency and were then sold at a higher price.
This article has also made brief mention of the fact that Bitcoins that are received as payment for goods or services must be taxed. Unlike Bitcoins that are obtained through a direct trade for fiat currency, the income realized from those Bitcoins must be reported and taxes must be paid on it immediately. This is true whether the recipient chooses to hold those Bitcoins in his or her wallet or exchange them for fiat cash the same day.
Using Bitcoins to pay for goods and services can also be a taxable event. The amount of taxes that the buyer will pay depends on how much the Bitcoins have appreciated or depreciated in value since their initial purchase. Even small purchases made in Bitcoin are considered taxable events.
While it is still uncommon for employers to make payments to their employees using Bitcoins, this would also be considered a taxable event. The employer must convert the Bitcoin payment into U.S. dollars using the fair market price of Bitcoin on the date of payment as a reference point, then report them to the IRS on W-2 forms. Just like regular dollar wages, Bitcoin payments are subject to tax withholding.
Employees paid in Bitcoins must also report their W-2 wages in U.S. dollars. Those who are self-employed and receive payments directly for services or goods provided to customers or clients should also note that their capital gains will be subject to self-employment taxes as well as income taxes. Bitcoin miners should report their earnings according to the Bitcoins’ fair market value on the day that they were mined.
The most common mistake most taxpayers make when reporting capital gains from Bitcoin and other cryptocurrencies is the failure to include all relevant data. Many users forget to include data from previous tax years, for example, and this can lead to unnecessary expenses, compliance issues, or both. The reason this is the case is that capital gains from Bitcoin transactions are determined using data not just from the date of sale but also from the date of acquisition, so taxpayers need to know how much their Bitcoins were worth the day of purchase, as well.
Bitcoin investors who use multiple exchanges should be careful to include information from each exchange. Some platforms issue 1099-K forms, while others do not. Ultimately, it’s up to taxpayers to keep track of their transactions.
One particularly costly mistake that is all too common is a failure to file Bitcoin losses as well as Bitcoin gains. When Bitcoins are sold for less than they were worth when they were purchased, it is considered a capital loss. This loss can be used to reduce consumers’ taxable income.
A Few Tax Tips
The best tip that anyone spending, receiving, or investing in Bitcoin can get when it comes to taxes is to keep detailed records of all transactions. These records should always be dated since Bitcoin value must be determined based on the virtual currency’s fair market value on the day of the transaction. Think of it like keeping track of stocks and act accordingly.
The disposition of Bitcoins must be reported on IRS Form 8949 and Schedule D. However, investors who engage in market-to-market trading of cryptocurrencies should note that all of their gains will technically be considered short-term and would need to be reported on Form 4797. On the plus side, this means that capital losses and Bitcoin-related expenses are also deductible on Schedule C.
The IRS has also released an official document, Notice 2014-21, to address many of the most common concerns that come up in regards to Bitcoin and taxes. Any investor or casual user who intends to fill out his or her own tax forms should take a look at this official document prior to getting started.
Those who are feeling overwhelmed with all of this information may be better off hiring a professional. Turbotax and other forms of tax accounting software are now making accommodations for crypto, as well.
The Bottom Line
Although Bitcoin and altcoins may be used like currency, in the eyes of the IRS they are still considered property and are thus taxed as property. Investors should choose when they sell their Bitcoins carefully, as the amount of tax they will pay on any capital gains will vary based on whether they have held the Bitcoins in their wallets for more or less than one year. In the event that Bitcoins are held as property for more than a year, the percentage of tax paid on any capital gains will also vary based on the taxpayer’s overall taxable income for the year.
Bitcoins that are held in an online wallet are not taxable. The IRS only needs to be involved when Bitcoins are received as payment for goods or services or they are sold for a profit. Failing to keep accurate records of Bitcoin taxes can cause investors and casual users alike some serious headaches come tax season. This is especially true given that the value of Bitcoins is determined based on their fair market value as of the date they were transferred not the date of filing.