Bitcoin may be an unregulated asset, but the IRS still wants a share of your transactions.
Bitcoin and other virtual currencies are taxable, which means all of your bitcoin transactions must be reported on your tax return.
“It doesn’t matter to the IRS — for U.S. taxpayers — where the bitcoin is acquired or disposed of. It must be reported on your tax returns and any income or capital gain or loss indicated,” says Steve Skancke, chief economic advisor at Keel Point.
That said, tax reporting on bitcoin can be as mind-boggling as the cryptocurrency itself. Here are a few points to help you figure out how bitcoin is taxed:
— Bitcoin is property, not currency.
— How you receive bitcoin matters for taxes.
— Reporting to the IRS.
Bitcoin Is Property, Not Currency
The first thing to know about Bitcoin is that it is property in the eyes of the IRS. Despite how you may view it or use it, the IRS says for tax purposes, bitcoin and other digital currencies are not currency; they’re capital assets, which means they’re taxed like stocks.
“Because the IRS views Bitcoin as a capital asset, it doesn’t make a difference whether you sell it as an investment or transfer it to another party as payment for goods or services,” Skancke says. “Any change between its value at time of sale or transfer and its cost of acquisition is treated as a capital gain or loss and taxed accordingly.”
This is actually good news for long-term bitcoin owners, as it means you’ll get more favorable tax treatment. “Currency is taxed at ordinary income rates, which is less favorable than capital gains tax rates,” says Eric Pritz, a senior partner with Signature Estate & Investment Advisors.
If you hold bitcoin for more than one year before selling it at a gain, you’ll only have to pay capital gains taxes of 15% (20% for individuals earning $441,450 or more and as low as 0% for individuals who earn less than $80,000). On the other hand, if you hold it for one year or less before selling, you’ll pay ordinary income tax rates on any gains based on your tax rate.
“If bitcoin is bought inside a retirement plan, such as a 401(k) or IRA, it is treated like other investment assets: There is no tax on gains, but retirement plan distributions are taxed as ordinary income,” Skancke says.
[Read: The History of Bitcoin]
How You Receive Bitcoin Matters for Taxes
How you receive and use bitcoin can impact the taxes you pay. For instance, mining bitcoin creates a taxable event. You’d need to calculate the fair market value of the bitcoin on the day it was mined and pay income taxes on it, says Tyson Romanick, a chartered financial analyst and portfolio manager at Baker Boyer.
You can determine the fair market value by converting the cryptocurrency into U.S. dollars (or into another real currency, which can then be converted into U.S. dollars) based on the established exchange rate listed on the exchange. The fair market value is whatever the cryptocurrency’s value is at the date and time the transaction is recorded on the distributed ledger. If the transaction is not recorded on the distributed ledger, then you can use the time it would have been recorded had it been a recordable event.
If you were then to use your bitcoin to buy a car, you’d need to determine the fair market value of the bitcoin on the day you make your car purchase. “You can look at it like you sold your bitcoin, but instead of getting money for it, you received another item of value,” Romanick says. The difference between the cost basis of your bitcoin, which is generally the amount you paid for it when you acquired it, and its fair market value on the day you bought the car will result in a gain or loss that you will report when you file your taxes.
There are few bitcoin transactions that don’t result in an immediate taxable event, such as if you receive bitcoin as a gift or donate it to charity. Once you dispose of your gifted bitcoin, however, you will need to pay taxes accordingly, which means you will need to know the cost basis of your gifted bitcoin. This depends on whether you have a gain or loss when you sell or dispose of it: If you have a gain, the basis is the donor’s basis plus any gift taxes the donor paid. If you have a loss, your basis is the lesser of the donor’s basis or the fair market value at the time you received the gift. And if you have no way of knowing the donor’s basis, then you get to record a cost basis of zero dollars.
If this sounds like a headache waiting to happen, it is. “I would recommend keeping things simple and avoid regularly buying goods and services with bitcoin until tracking tools have improved,” Pritz says.
[Read: The Best Bitcoin Wallets.]
Reporting to the IRS
As you can likely see, keeping meticulous records of your bitcoin transactions is key when tax time comes around. Unfortunately, since owning digital currency isn’t as straightforward as owning stocks, the institution you hold your currency at may not issue a 1099 form to help with your tax reporting, Pritz says. “It is up to you to notify the IRS of any gains and losses associated with bitcoin taxable events.”
The IRS recommends keeping records documenting any receipts, sales, exchanges or other dispositions of digital currency and the fair market value at the time of the transactions.
The potential silver lining is that while you must account for capital gains from bitcoin, you can also deduct capital losses, says Ben Weiss, chief operating officer of CoinFlip, one of the largest crypto ATM providers in the U.S.
“This year, the IRS has updated the 1040 tax return form to ask taxpayers directly on-page whether they have ever received, sold, sent, exchanged or otherwise acquired any cryptocurrency,” he says. “So anyone who makes income from cryptocurrency must report that income and pay the required tax.”
The Financial Crimes Enforcement Network also recently announced it intends to change the Report of Foreign Bank and Financial Accounts’ requirements to include cryptocurrencies in foreign accounts as a reportable account.
“Typically, individuals must report any financial interests outside of the country that exceeds $10,000,” Weiss says. With this change, cryptocurrencies like Bitcoin will count as financial interests that need to be reported.
And don’t think you can just “forget” to report. “The IRS is very aware of these pitfalls and is continually increasing their tracking and scrutiny of this emerging investment,” Pritz says.
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Correction 02/18/21: A previous version of this story misrepresented information paraphrased from a source.