Bitcoin Taxes: How to Play by the IRS’ Rules

Cryptocurrencies captivate and confuse investing enthusiasts and financial pros alike. Are they a smart investment option that will eventually show major gains or a popped bubble? Could they ever be part of a traditional investment portfolio or will they always be an outlier? And how will the Internal Revenue Service (IRS) and other financial regulatory agencies handle any monetary gains coming from Bitcoin, Litecoin, Ethereum, or other cryptocurrencies?

Are there taxes on Bitcoin or other cryptocurrencies?

In a word: Yes. Bitcoin taxes exist. But unlike some sections of the tax code, which can number in the hundreds of pages, the regulations surrounding cryptocurrency and bitcoin taxes are relatively brief. Released in 2014, the IRS’s guide on the tax treatment of virtual currency transactions is only seven pages long. The notice states that virtual currency is property, should be treated as such, and, depending on the transaction, may be liable to taxes based on its value on the day of receipt. The IRS also has a virtual currencies FAQ page to answer your questions about cryptocurrency tax.

If you purchased Bitcoin or another form of cryptocurrency and have it in a virtual wallet as the value rides the market, it is treated similarly to other types of investment vehicles for tax purposes. In short, you don’t need to pay taxes on the crypto itself. That’s because, even though “currency” is in the name, the IRS classifies cryptocurrency as property, which means that it’s treated similarly to a house, stocks or bonds. What this means: If you aren’t withdrawing, selling, or trading any funds, then there is no need to declare your cryptocurrency as part of your tax return.

However, you will need to report gains — or losses — to the IRS through a Schedule D (1040) form, if you have either:

• “Mined” Bitcoin
• Used it to buy goods
• Received Bitcoin as payment
• Traded or sold cryptocurrencies

Also, if you regularly use Bitcoin instead of cash or credit to purchase items online, it’s important to remember that once Bitcoin is converted to an asset — either cash or goods — the transaction becomes taxable.

Unlike sales of stocks or bonds, where you’re likely to receive a 1099 from your bank or brokerage, it’s up to you to report gains or losses to the IRS yourself. As per the IRS, any gains or losses with cryptocurrency are based on the value of the cryptocurrency at the time that it was bought, sold, or received as payment. Cryptocurrency values constantly fluctuate, so it’s a good idea to get in the habit of tracking values.

If you’re primarily buying or selling cryptocurrencies, you’ll likely be able to download transaction data from your wallet provider, but will need to look up the relative cost of the cryptocurrency bought, sold, or used on the day of the transaction. For example, if you paid for a product from an online vendor with Bitcoin, it’s up to you to assess how much the Bitcoin was worth at the time of sale. That purchase is considered a “taxable event” making your Bitcoin subject to taxes.

Websites like Cointracking.info and Bitcoin.tax are a few of the available online resources that can help you determine tax liabilities.

How much is Bitcoin taxed?

How cryptocurrencies are taxed depends on the length of time you’ve held the cryptocurrency. If you’ve owned the cryptocurrency for less than a year, it’s taxed as a short-term capital gain — the same as your ordinary income tax rate. If the cryptocurrency is held for longer than a year, then any gains will be taxed like long-term capital gains.

For 2020 and 2021, ordinary income tax rates range from 10% to 37%, depending on your income. For most taxpayers, long-term capital gains are taxed at zero, 15%, and 20% depending on your tax rate. According to the IRS, this means if your ordinary income tax rate is below 15%, you may pay zero on long-term gains. Even if you are in a high tax bracket, you’re going to be paying far less on your long-term capital gains than you are for ordinary taxes, which means that it may be a smart idea to hold onto your cryptocurrency for as long as possible.

Again, bitcoin taxes are dependent on cryptocurrency converting into what the IRS views as a taxable event. In a nutshell, a taxable event is either converting the crypto to cash or using the crypto in a cash-like way.

For example, let’s say a neighbor offers to unload their old car to you for one bitcoin. In the eyes of the IRS, this would be similar to you converting the cryptocurrency to cash (even though no cash changed hands) and it’s up to you to pay taxes on the difference between what you paid for the crypto and what it was worth on the day the sale of the car is final.

Let’s say that you purchased Bitcoin in June 2013, when one bitcoin was valued at about $100. Your neighbor offers to trade her car for one Bitcoin in December 2018, when Bitcoin is valued at $4,000. Because you’ve owned the Bitcoin for over a year, this transaction is seen as a long-term capital gain and taxed at your capital gains rate, which is lower than your income tax rate.

And if you did end up recently losing money in the Bitcoin bubble, it could be possible to use your cryptocurrency transactions as a way to write off the loss on your taxes.

For example, let’s say you purchased one Bitcoin in December 2017, when one Bitcoin cost nearly $18,000. In December 2018, your neighbor offers to sell you her car for one Bitcoin — the day that the currency’s value was at nearly $4,000. Since you lost money in this transaction, you can report a short-term capital loss. But this strategy may have limitations: Even though your Bitcoin lost $14,000 in value from the day you bought the cryptocurrency to the day you transferred it to your neighbor, you’re limited in the loss you can report. The IRS caps short-term capital losses at $3,000 per year on personal tax returns, so you might have to carry that loss forward for years.

However, if you regularly use Bitcoin, it’s also important to be aware that the IRS views any gains from crypto transactions as subject to the net investment income tax if your combined investments (from rental properties, dividends, or other capital gains) is above a certain threshold ($200,000 for single filers in 2020).

If you “mine” for bitcoin, it’s also important to note that the IRS views this activity as employment, with the profits taxable as self-employment income. If your state has income tax, any losses or gains will also be subject to state tax as well.

How to stay out of trouble with the IRS

As cryptocurrency becomes more and more mainstream — and tracking tools become more adept at flagging crypto buys, sells, and trades — bitcoin gains will likely become more heavily scrutinized by the IRS. Along with the rise of cryptocurrency has come the rise of financial pros who have mastered the ins and outs of crypto and bitcoin taxes, as well as how to handle various crypto movements in the market, like “airdrops,” where new forms of cryptocurrencies are given to current investors.

The more you consider how you use crypto, the more questions you may have about how your crypto will be taxed. For example, can you donate crypto to charity? Right now, the answer is yes, with crypto being considered property — similar to gifting stock or real estate — in the eyes of the IRS. If you are planning to donate crypto to charity, it may make sense to donate the cryptocurrency directly to the charity (instead of converting the crypto to cash and donating the equivalent amount) so the charity can receive the full cash value of your crypto gift.

While you can write off the value of your crypto gift on your taxes, you will still be responsible for any capital gains taxes on the money you gave. But if you give the crypto directly to a 501(c)(3) charity while still in crypto form, the 501(c)(3) charity will be exempt from capital gains taxes when the crypto is converted to cash, maximizing the effectiveness of your gift.

Finally, if you’re donating over $500 in cryptocurrency value to a charity, it’s important to make sure to document your donation as though you were documenting any other gift of property. The IRS requires any non-cash gift to be documented with Form 8283, which also applies to crypto.

It’s important to recognize that crypto tax events are subject to worldwide income tax for US residents and citizens regardless of where the crypto originated or where in the world you purchased goods using crypto. And if you’re buying or trading cryptocurrency on a foreign exchange and own over $10,000 in assets, it may be worth speaking with a financial professional who specializes in cryptocurrency. You may need to file a Report of Foreign Bank and Financial Accounts (FBAR) form with the IRS.

As with any tax-related question or concern, more information is better than less information. Consulting with a tax professional, tax lawyer, or financial planner who has experience in cryptocurrency is usually a much better idea in the long run than hoping that you can figure out the right tax move on your own. Just because crypto is a new form of property doesn’t mean that new rules apply to tax evasion. Failure to pay taxes on crypto gains are subject to tax evasion penalties, including potential criminal charges of tax evasion or filing a false tax return, according to a statement from the IRS.

Bottom Line

Even if you’re not actively using crypto to sell, trade, or buy, it makes sense to become familiar with the tax rules surrounding bitcoin now — and realize things are likely to become more codified in the future. Even if you don’t currently own crypto, knowing the way crypto is viewed and how cryptocurrency can evolve from a short- to long-term gain depending on the length its held can help you consider how you might use crypto in the future — or encourage you to hang on to whatever is in your wallet now.

Understanding how the fluctuation of bitcoin prices can work in your favor — and how taxes could potentially affect any purchase or financial move made with crypto — can also help you see the full financial picture. Taking the time to report any crypto transactions now means you won’t need to refile taxes later, saving time and giving you a clear conscience, too.