In 2014, the IRS has ruled that Bitcoin and other "convertible virtual currencies" must be treated as property, not as currency. There are, therefore, tax consequences whenever Bitcoin is bought, sold, or traded.
This might sound like a minor distinction, but it's not. It determines how Bitcoins are taxed, the information you'll need to make sure your taxes are calculated correctly, and what tax-planning techniques you can use to try to minimize your taxes on Bitcoin transactions.
The IRS and Virtual Currency
The IRS has indicated that virtual currency doesn't have status as legal tender in any jurisdiction. It's referred to as "convertible" virtual currency if it has an equivalent value in real currency, or if it ever serves in place of real currency. It can be exchanged into another currency, either real or virtual, and it can be digitally traded.
When Do You Have to Pay Taxes on Bitcoin?
The IRS further indicates that Bitcoin is treated as property and is subject to general tax principles. You must include in the fair market value of the currency in U.S. dollars in your gross income if you're paid in Bitcoins for goods or services. Transactions using virtual currency should be reported in U.S. dollars.
The fair market value of Bitcoins can be established by converting them into U.S. dollars at the current exchange rate at the time they're received.
You'll also have a capital gain or a capital loss if you dispose of Bitcoin, because it's considered property for tax purposes. A gain represents income, and income is taxable even if you're paid in virtual currency.
"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."
As with other types of property, you would acquire it first, often by exchanging cash for the asset. You then own the property for a period of time, and you might eventually sell it, give it away, trade it, or otherwise dispose of it. Capital gains taxes come due at this point.
Four things will 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 or purchase price and the gross proceeds received from the disposition or the selling price.
- The tax rate that applies depends on whether the property was held for one year or less (a short-term gain) or for more than a year (a long-term gain).
- 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. You'll do your calculations right on the form, per instructions.
Reporting Cryptocurrency Activity
Virtual currency transactions must be reported on page 1 of your individual tax return. Beginning in 2020, if you engage in any transaction involving virtual currency, you must check the appropriate box next to the question on virtual currency, even if you received any for free, including from an air-drop or hard fork. Do not check this box if you only engaged in transactions among wallets that you yourself own.
An Example of Capital Gains Tax
Suppose you purchased Bitcoin for $30,000. You then sell it for $50,000, so you have a $20,000 capital gain. This would be a short-term gain if you held the Bitcoin for a year or less, so it would be taxed as ordinary income according to your tax bracket. It's a long-term gain taxed at a rate of either 0%, 15%, or 20%, depending on your overall income, if you owned the Bitcoin for longer than a year.
The Net Investment Income Tax
You might also find that you're subject to the 3.8% net investment income tax that applies to investment income. It comes due if you're a single taxpayer, and your overall modified adjusted gross income (MAGI) from all sources is more than $200,000 for the year. The threshold increases to $250,000 for married taxpayers who file jointly and qualifying widow(er)s. It drops to just $125,000 for married taxpayers who file separate returns.
This additional 3.8% tax rate applies only to investment income, not wages or most self-employment income.
How to Pay Taxes on Bitcoin
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.
Normal capital gains strategies apply: You can 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. The income is reportable on your personal tax return, normally due April 15 of each year unless you request a six-month extension from the IRS. (Because of pandemic-related complications, the deadline for filing 2020 personal tax returns is May 17, 2021.)
What Happens If You Don't Pay Taxes?
Bitcoin is no different from other sources of taxable income if you shrug your shoulders at the IRS and don't pay, even if you didn't know you were supposed to do so.
First, the IRS will most likely know about your activities, or at least it can check and confirm them. All Bitcoin transactions are permanently stored in the Bitcoin network, which is public.
You'll no doubt receive a notice from the IRS if you neglect to pay taxes on this income. You'll be charged interest at the rate of 0.5% of the amount of tax you owe, up to a cap of 25% of the unpaid balance. You'll also be penalized at the rate of 5% a month as of 2020.
The IRS additionally has numerous enforcement options for collection, from liens against your property to levies on your income and bank accounts.
Tax Tools for Bitcoin
Casual Bitcoin users might want to consider using a reputable Bitcoin wallet provider that has implemented risk-mitigation tools to make buying, trading, and selling Bitcoin more secure and user-friendly. Even aside 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.
These tools might come in handy both when you're handling transactions and when you're planning for taxes.
BitcoinTaxes, web-based software for importing data and calculating gains/losses, can be helpful as well.