Bitcoin prices have been a rollercoaster ride over the past several years. Some investors have realized significant windfalls and others have experienced losses. In either case, it’s important to properly account for your bitcoin taxes to ensure that you remain on the right side of the law and potentially realize tax deductions.
In this article, we will take a look at how the IRS treats Bitcoin and other cryptocurrencies and how to include Bitcoin tax gains and losses in your tax return to avoid any problems!
How Is Bitcoin Taxed In The United States?
Bitcoin was originally designed to be a digital representation of value that functions like a “real” currency (e.g., the coin and paper form of money). In the original white paper, Satoshi Nakamoto designed the cryptocurrency to avoid the need to trust third-party financial institutions to process payments, reduce transaction costs, and pave the way for microtransactions.
But even with these goals, the IRS treats bitcoin as taxable property like stocks or real estate, and you must report capital gains or losses and pay the appropriate bitcoin tax rates. These tax rates depend on how long the position was open and your individual tax bracket during a given year.
Understanding Bitcoin And Taxes
The IRS has made it clear that Bitcoin does not have legal tender status in any jurisdiction and must be treated as property for federal tax purposes. Property gains are subject to federal ordinary income or capital gains taxes, unlike foreign currency gains or losses. This includes Bitcoin purchased for investment, received as compensation, or mined by computers.
Do All Bitcoin Holders Have To Pay Bitcoin Taxes In The US?
Bitcoin owners are regulated to pay federal income tax on Bitcoin, i.e., any capital gains realized upon the exchange of Bitcoin for U.S. dollars, euros, virtual currencies, or other assets. In practice, this means that you must compute the fair market value and cost basis to determine the gain or loss on the transaction. The cost basis is especially important to track because you may owe tax on the entire proceeds without any accurate cost basis.
How Is Bitcoin Taxed: Are All Bitcoin Transactions Taxable?
The Internal Revenue Service (IRS) states that the following Bitcoin transactions would have tax implications:
- Selling Bitcoin that you have bought from someone or mined yourself to a third party
For example, you mined some Bitcoin worth $2,000 and sold it at $3,500. So you will have a capital gain of $1,500 and this gain will be subjected to long or short-term capital gains tax, depending on the holding time of the asset.
The tax implications remain the same even if the Bitcoin was purchased from a cryptocurrency exchange or received from another person.
- Using Bitcoin that you have bought from someone or mined yourself to buy goods and services
For example, if you buy pizza with Bitcoin mined at home, you must pay taxes on the transaction. The amount of taxes levied is determined by the transaction's characteristics, such as the value of Bitcoin at the moment of sale and the price of the pizza.
Bitcoin Taxes: Capital Gains Tax Or Ordinary Income Tax?
If you do fall in the category of Bitcoin holders that must pay a tax, you must first determine whether to pay capital gains or ordinary income tax on Bitcoin. Here's a brief breakdown of the two.
- Ordinary Income: Ordinary income taxes apply when Bitcoin is not a capital asset. For example, a retailer that accepts Bitcoin or a consultant paid in Bitcoin would report any gains as ordinary income.
- Capital Gains: Capital gains taxes apply when the Bitcoin is held as a capital asset, like a stock or bond. For example, an investor that believes Bitcoin prices will rise might have purchased Bitcoin a few years ago and sold it at a profit.
Here are the events that’ll trigger income taxes:
- Acquiring cryptocurrency using an airdrop
- Any cryptocurrency interest revenues from lending through decentralized finance (DeFi)
- Cryptocurrency obtained through liquidity pools and staking
- Earnings from cryptocurrency mining include block rewards and transaction fees.
- Receiving cryptocurrency as a reward for performing tasks, such as bug bounties
It must be noted that the capital gains tax rates are often lower than ordinary income tax rates, so it’s important to determine the correct tax treatment to avoid overpaying taxes. Individual tax rates vary widely depending on a person’s income, dependents, tax credits, tax deductions, and other factors.
The IRS also outlines a few edge cases that apply to Bitcoin Miners and Bitcoin Compensation:
- Bitcoin Miners: Bitcoin miners must include the fair market value of the cryptocurrency at the date of receipt in their gross income. In addition, they must pay self-employment taxes as any small business would, although they can also deduct any expenses associated with mining on their tax return.
- Bitcoin Compensation: Consultants that accept Bitcoin must include the fair market value of the cryptocurrency on the date received for services performed as an independent contractor. Bitcoin paid by an employer for remuneration for services also constitutes wages for employment tax purposes.
Does the IRS Track Cryptocurrency?
The IRS introduced a cryptocurrency question on Schedule 1 of Form 1040 in 2019. The simple YES or NO question asked whether you received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during the year. That said, Schedule 1 is an easy-to-miss addendum for declaring additional income that most Americans never fill out.
In 2020, the IRS moved the cryptocurrency question to the top of Form 1040. The move effectively requires every American to answer the question, which eliminates any chance of accidentally forgetting to answer the question or feigning ignorance. If answered incorrectly, taxpayers could be subject to fines and penalties beyond any accidental underpayment.
Taxpayers must answer YES if they received any cryptocurrency for free, including via airdrops or hard forks, as well as if they used cryptocurrency to purchase physical goods, like coffee. Those that are merely holding cryptocurrencies, or transferring them between wallets they own, may be able to answer NO as long as they didn’t transact in any way.
Many crypto experts see the move as a trap for crypto traders and investors that have thus far feigned ignorance to avoid paying taxes. When filing their 2021 tax return, taxpayers should ensure that they answer the question truthfully in order to avoid a host of future repercussions, particularly as the agency gears up to prosecute more crypto-related cases.
Additionally, the US government has even proposed a new rule allowing them to track anyone's fishy cryptocurrency transactions without the need for a warrant. So basically, yes, the IRS can track your crypto if they should want to.
Can You Avoid Paying Taxes On Bitcoin?
With this Bitcoin tax guide or crypto tax guide, we advised to not commit a crypto tax fraud provided that over the past couple of years, the IRS has become increasingly aggressive in its enforcement of cryptocurrency taxes. The agency sent out warning letters to taxpayers suspected of owning cryptocurrencies warning them to fix discrepancies in their tax filings before it escalates the situation into a full inquiry or even a costly and time-consuming audit.
In mid-2020, the IRS began soliciting expert contractors to help audit cryptocurrency-related tax returns. The agency appears to be interested in analyzing blockchain transactions in order to identify taxpayers and prove that they have generated taxable capital gains. These efforts could be a prelude to greater levels of enforcement in 2021 and beyond.
These escalations have come despite concerns by the agency’s own internal watchdog group. The Taxpayer Advocate Service alleged that one of the agency’s warning letters undermined taxpayer rights by demanding a statement of facts and a detailed trading history accounting for years outside of the statute of limitations while using a “disturbing” tone.
How To Report Bitcoin On Taxes?
The process of preparing taxes can be very challenging even before including Bitcoin gains and losses, but fortunately, it is starting to get easier. Cryptocurrency exchanges are making it easier than ever to comply with these laws. Coinbase and other major exchanges provide 1099-MISC forms to individuals with large enough gains and provide everyone with easy access to their transaction history. This is especially helpful for crypto-to-crypto transactions.
ZenLedger crypto tax software makes it easy for you by aggregating data from numerous exchanges, calculating your taxes, and generating common IRS forms like Form 8949 and Schedule D during tax season. If you experienced Bitcoin losses, you can even automate the process of harvesting those losses to offset other gains. These capabilities reduce the amount of time that your CPA requires to file your taxes—potentially lowering your costs.
Read more about the benefits of a Bitcoin Tax Calculator.
Tips For Reporting Taxes And Preparing For The Tax Season
1. Keep a record of all your crypto transactions
You'll need records of your bitcoin's fair market value when you mined or bought it as well as its fair market value when you used or sold it. You’ll also need to record the date of the transactions. This information will assist you in calculating your bitcoin taxes.
2. Sort out your tax documents
Spend some time organizing your tax documents and financial records to make the filing process faster and easier. To determine your previous income, deductions, and credits, use your prior year's tax return as a starting point.
3. Decide if you want to hire a crypto certified public accountant (CPA) or do it yourself
A CPA is a trusted financial counselor who assists corporations, people, and other organizations in planning and achieving their financial objectives. A crypto CPA can assist you with tax preparation and more.
Increased IRS Enforcement on Bitcoin Taxes & What It Means for You
ZenLedger’s Chief Operating Officer, Dan Hannum, gave an interview to The Wall Street Journal about the IRS gearing up to deploy a change to the 2020 tax form that directly affects crypto investors. By now, it is no secret that the IRS has a plan for increased enforcement on crypto.
For context, 2019 was the first time the IRS asked if an individual had participated in buying, selling, or holding digital assets by putting the question on the Schedule 1 form — not necessarily requiring an answer. But fast-forward just 1 year later, and the IRS has chosen to highlight the question on the first page and place it above the fold on the Standard 1040 tax form. In changing the positioning of the question, the IRS is now requiring an answer to this question.
- “At any time during 2020, did you sell, receive, send, exchange, or otherwise acquire any financial interest in any virtual currency?” You must either check “Yes” or “No”
What Does This Mean for the Average Bitcoin Investor?
In 2020, global users holding crypto assets surpassed 100,000,000 and the IRS has become more serious about compliance. Even if you have multiple exchanges and wallets spread across various platforms, you’ll need to gather all of your transactions and report on them.
The Latest Bitcoin News
Mayor Steve Adler of Austin, Texas proposed two measures to make the city a global leader in the crypto arena. Firstly, he focuses on promoting the benefits of blockchain technology and Web3, and lauded Bitcoin claiming that it is a store of value, has improved security, and allows for immediate transactions beyond geographical and political boundaries.
Secondly, he encourages people to use bitcoin as a payment mechanism. He believes that Austin should follow Miami and New York's lead and engage more deeply with the top digital asset. He advocated, in particular, that BTC be accepted as a payment mechanism for municipal taxes, fines, and penalties.
In other news, a judge at Washington County ruled that Red Dog Technologies' mining operation is in violation of the A-3 (agricultural business) zoning law. The company's lawyer claimed in court that Red Dog offered a public utility-like service, but the judge finally concluded that bitcoin mining — the process of using blockchain technology to verify Bitcoin transactions, did not fit into this category. However, an appeal request was approved.
The Bottom Line
Bitcoin prices have experienced considerable volatility over the years, resulting in significant gains and losses for investors. At the same time, the IRS and SEC have stepped up their enforcement actions to ensure that crypto companies are playing by the rules and crypto investors are paying their fair share.
Thankfully, ZenLedger can help you easily file your bitcoin taxes as we offer integration with all major players and full DeFi support. We can even help you amend previous tax year forms! The best part: ZenLedger has live support available 7 days a week by online chat, email, phone, or by appointment — we want to help you succeed in navigating these waters.
There is no doubt that there will be an increased IRS enforcement tax on Bitcoin in 2021, but with ZenLedger and our crypto tax calculator, we can help take away the stress and simplify the complicated bits.
Disclaimer: This material has been prepared for informational purposes only and is not intended to provide, tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.