How Bitcoin Is Taxed
The IRS says bitcoin is property and can be subject to capital gains tax
Whenever bitcoin is bought, sold, or traded, there are tax consequences. The Internal Revenue Service has ruled that bitcoin and other "convertible virtual currencies" are "treated as property," not treated as currency.
This might sound like a minor distinction, but it's not. It determines how bitcoins are taxed, what information you'll needed to make sure your taxes are calculated correctly, and what tax planning techniques you can use to minimize your taxes on Bitcoin transactions.
The Big Picture
You'll have a capital gain or a capital loss when you dispose of bitcoin because virtual currencies are considered property for tax purposes. A gain represents income, and income is taxable even if you're paid in virtual currency.
Spending virtual currency is another matter. You'd actually have two transactions in one: You're effectively disposing of the virtual currency and spending the dollar-equivalent amount.
What Is Virtual Currency from a Tax Perspective?
According to the IRS, "Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. It does not have legal tender status in any jurisdiction. Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as 'convertible' virtual currency.
"Bitcoin is one example of a convertible virtual currency because it can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, euros, and other real or virtual currencies."
Tax Treatment of Bitcoin
The IRS also says in Notice 2014-21, "For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.
"Transactions using virtual currency must be reported in U.S. dollars. Taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars ... at the exchange rate, in a reasonable manner that is consistently applied."
When Virtual Currency Treated as Property
Yes, it sounds complicated. Let's break it down into plain English.
"Every bitcoin transaction is taxable," writes Tyson Cross, a tax attorney who specializes in virtual currencies. "Bitcoin users will have to calculate their gain or loss every time they purchase goods or services with bitcoin."
So what does that mean? The IRS said that bitcoin and similar convertible virtual currencies are property for tax purposes. As with other types of property, you first acquire property, often by exchanging cash for the property, then you own the property for a period of time. Eventually, you might sell, give away, trade, or otherwise dispose of the property.
So we have three moments in time that are critical to taxation of any type of property, including convertible virtual currencies: when you acquire it, how long you hold it, and when you dispose of it. The taxman comes when you dispose of it.
When Bitcoin Is Sold
Four things happen when property is disposed of:
- Income is realized from any gain.
- Gain is measured by the change in the dollar value between the cost basis (the purchase price) and the gross proceeds received from the disposition (the selling price).
- The tax rates that apply depend on whether the property was held for a short-term or a long-term period.
- Disposition of property is reported on your tax return using Schedule D and Form 8949 or Form 4797. These forms require that you "show your math" when you're calculating a gain or loss.
Let's assume that you purchase bitcoin for $30,000. You then sell it for $50,000 so you have a $20,000 gain. If you held the bitcoin for a year or less, this is a short-term gain so it's taxed as ordinary income according to your tax bracket. If you held the bitcoin for longer than a year, it's a long-term gain taxed at a rate of either 0, 15 or 20 percent depending on your overall income.
Tax Tips for Casual Bitcoin Users, Investors, and Speculators
Establish a record-keeping system for all your transactions and keep track of when you acquire and when you dispose of bitcoin. Identify your cost basis method and your exchange rate. Then record the dispositions of bitcoin on Schedule D and Form 8949.
Keeping detailed records of transactions in virtual currency ensures that income is measured accurately. "The key thing is maintaining records, substantially similar to stock," says Jason Tyra, a certified public accountant in Texas who specializes in bitcoin. "Incomplete records might as well be no records."
Casual bitcoin users might want to consider using a reputable bitcoin wallet provider. Wallet providers have implemented risk mitigation tools to make buying, trading, and selling bitcoin more secure and user-friendly. Apart from tax considerations, investors should take a look at wallet providers or registered investment vehicles with the kind of security features that one might expect from a banking institution. Some platforms offer to "insure holdings or store holdings offline in a vault," says David Berger.
Normal capital gains strategies apply: offset gains with losses, time your dispositions to qualify for long-term treatment, harvest your losses, and harvest your gains. A tax professional can help you with these concepts.
And keep an eye on the tax rates. Gains are subject to the 3.8 percent net investment income tax.
If you elect market-to-market trading, this would mean that all your gains are short-term and you would therefore report them on Form 4797. Any bitcoin-related expenses would be deductible on Schedule C.
Software Tools for Tracking Bitcoin
These tools might also come in handy when you're handling transactions and planning for taxes.
- LibraTax: Web-based software for importing bitcoin transactions and calculating gains/losses.
- BitcoinTaxes: Web-based software for importing data and calculating gains/losses.
- PayByCoin add-on for Quickbooks Online customers for merchants to accept payment via bitcoin and reconcile the data inside the online version of Quickbooks.