Around the world, tax authorities have tried to bring forth regulations on bitcoins. The US Internal Revenue Service (IRS) and its counterparts from other countries are mostly on the same page when it comes to treatment of bitcoins. The IRS said that the bitcoin should be treated as an asset or an intangible property and not a currency, as it is not issued by central bank of a country. The IRS answered some common questions about the tax treatment of Bitcoin transactions in its recent Notice 2014-21. Tax treatment depends on how Bitcoins are held and used. Bitcoin’s treatment as an asset makes the tax implication clear.
Before we get lost in a forest of jargon, here’s a handy glossary for common tax terms, which in this case apply to buying and selling bitcoin:
- Capital asset: Basically anything you own, from a house to furniture to stocks and bonds — and bitcoin.
- Basis: The amount you paid to buy bitcoin (including any fees you paid).
- Realized capital gain or loss: The profit or loss you made when you sold bitcoin (i.e. the price you sold it for minus your basis). Losses can be deducted from your taxes (more on this below).
- Unrealized gain or loss: The profit or loss you have on paper but have not actually cashed in on. You do not pay taxes on unrealized gains until you sell, at which point it becomes a realized gain or loss.
- Short-term capital gain: Realized gain on bitcoin or any other investment held for one year or less before selling it.
- Long-term capital gain: Realized gain on bitcoin or any other investment held for longer than one year before selling it.
Bitcoin investments are taxed as a capital asset
To properly pay taxes on an investment in bitcoin, you’ll need to wrangle some information from each sale you conducted over the last fiscal year. This includes the basis for each amount of bitcoin you sold, the date you bought it, the date you sold it, and the price at which you sold it. You can use these figures to calculate your realized gains or losses for each sale.
You can also use the dates to figure out whether the specific sale qualifies as a short-term gain or a long-term gain. Short-term gains are taxed like regular income, so the rate is equal to your federal income tax bracket. Long-term gains are taxed at a lower rate, but still according to your income level.
The breakdown is as follows:
- People in the 10% and 15% brackets pay 0%.
- People in the 25%, 28%, 33%, and 35% brackets pay 15%.
- People in the 39.6% bracket pay 20%.
The IRS has made it mandatory to report bitcoin transactions of all kinds, no matter how small in value. Thus, every US taxpayer is required to keep a record of all buying, selling of, investing in, or using bitcoins to pay for goods or services (which the IRS considers bartering). Because bitcoins are being treated as assets, if you use bitcoins for simple transactions such as buying groceries at a supermarket you will incur a capital gains tax (either long-term or short-term depending on how long you have been holding the bitcoins). When it comes to bitcoins the following are different transactions that will lead to taxes:
- Selling bitcoins, mined personally, to a third party.
- Selling bitcoins, bought from someone, to a third party.
- Using bitcoins, which one may have mined, to buy goods or services.
- Using bitcoins, bought from someone, to buy goods or services.
Scenarios one and three entail mining bitcoins, using personal resources, and selling them to someone for cash or equivalent value in goods and services. The value received from giving up the bitcoins is taxed as personal or business income after deducting any expenses incurred in the process of mining. Such expenses may include the cost electricity or the computer hardware used in the mining of bitcoins. Thus, if one is able to mine 10 bitcoins and sell them for $250 each. You have to report the $2500 as taxable income before any deductible expenses. According to the IRS, when a taxpayer successfully “mines” Bitcoins and has earnings from that activity whether in the form of Bitcoins or any other form, he or she must include it in his gross income after determining the fair market dollar value of the virtual currency as of the day he received it. If a bitcoin miner is self-employed, his or her gross earnings minus allowable tax deductions are also subject to the self-employment tax.
Scenarios two and four are more like investments in an asset. Let’s say bitcoins were bought for $200 each, and one bitcoin was given up in exchange of $300 or equivalent value in goods. The investor has gained $100 on one bitcoin over the holding period and will attract capital gains tax (long-term if held for more than one year, otherwise short-term) on $100 earned by selling/exchanging the bitcoin.
Short-term versus long-term gains
If bitcoins are held for a period of less than a year before selling or exchanging, a short-term capital gains tax is applied, which is equal to the ordinary income tax rate for the individual. However, if the bitcoins were held for more than a year, long-term capital gains tax rates are applied. In the US, long-term capital gains tax rates are 0% for people in 10%-15% ordinary income tax rate bracket, 15% for people in the 25%-35% tax bracket, and 20% for those in the 39.6% tax bracket. Thus, individuals pay taxes at a rate lower than the ordinary income tax rate if they have held the bitcoins for more than a year. However, this also limits the tax deductions on long-term capital losses one can claim. Capital losses are limited to total capital gains made in the year plus up to $3000 of ordinary income.
With all the surges in price, it’s hard to imagine bitcoin falling in value. But if the supposed bubble does pop, it helps to know you can deduct the losses on your tax return — even if you take the standard deduction. (This is an “above the line” deduction. Student loan interest is a common one most people already claim.)
To calculate the loss, just subtract the sale amount from the basis. Assuming you have no other gains to subtract the loss against, your deduction will still be proportional to your income. So if our hypothetical investor lost $1,000 in bitcoin, and that was her only realized gain or loss this year, her income level would impute an approximate tax savings of $250.
Keep in mind, however, that the IRS caps capital loss deductions at $3,000 annually. Anything above that will roll over each year until the remainder is depleted.
Foreign asset reporting requirements
The US Treasury wants to know if American residents own foreign assets. Where is your bitcoin account based? Is that where your bitcoins are held? Non-US holdings need to be reported to the Treasury using FinCen form 114, and for the IRS it’s form 8938. That said, US citizens and residents who own less than $10,000 of assets abroad generally don’t need to worry about this.
Hard forks happen when the software for a digital asset is changed for some reason, usually to improve it. This summer, bitcoin cash was created to speed up transactions. Anyone who owned bitcoin before the split ended up owning both afterwards. Is this like a stock split? A spinoff? A gift? Someone who bought bitcoin before the fork didn’t necessarily ask for bitcoin cash, want it, or even know that they now own it.
The thing is, it probably counts a taxable income, according to Forbes, which points out that the IRS has a “long and successful history of treating ‘free money’” as taxable income. People who owned bitcoin before the hard fork will have to figure out the fair market value of bitcoin cash when it came into being, for cost-basis purposes. Futures markets suggest that it was worth around $275 at the time of the fork on Aug. 1.
When the bill comes due
It may sound basic, but even the most ardent crypto-enthusiast who eschews fiat money needs to have dollars on hand to pay their final tax bill. If, say, the bitcoin bubble pops next year, taxpayers could still owe money to the IRS depending on gains or income achieved through trading during the year, swaps between digital assets, or hard forks. This is basically what happened to tech workers in 2001, who exercised stock options before the dot-com bubble burst. For various arcane reasons, some of these workers owed far more in taxes than their stock was worth when the time came to pay the tax man.
A final note
Taxation on bitcoins and its reporting is not as simple as it seems. For starters, it is difficult to determine the fair value of the bitcoin on purchase and sale transactions. Bitcoins are very volatile and there are huge swings in prices in a single trading day. The IRS encourages consistency in your reporting; if you use the day’s high price for purchases, you should use the same for sales as well. Also, frequent traders and investors could use “first in, first out” (FIFO) or “last in, first out” (LIFO) accounting techniques to reduce tax obligations.