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 how to include Bitcoin tax gains and losses in your tax return to avoid any problems and realize benefits.
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, as well as reduce transaction costs and pave the way for micro transactions.
But even with these goals, the IRS treats bitcoin as property for tax purposes. As with stocks or real estate, 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 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 I Have to Pay Bitcoin Taxes?
You must pay federal income tax on any 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.
Capital Gains and Bitcoin Taxes
Next, you must determine whether to pay capital gains or ordinary income tax on the amount:
- Ordinary Income: Ordinary income taxes apply when the 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.
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 may apply:
- 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.
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 to calculate their cost basis as well as add up their gains and losses for the year. This is especially helpful for crypto-to-crypto transactions.
ZenLedger crypto tax software takes things a step further by aggregating data from numerous exchanges and automatically filling in 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 or your total income tax liability. These capabilities will reduce the amount of time that your CPA requires to file your taxes—potentially lowering your costs.
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”.
- Have You Received An IRS CP2000 Letter? Here Are Your Next Steps
- The IRS and Crypto: Campaign Against Bitcoin Tax Evasion
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 much more serious about compliance and all crypto gains, losses, and even passive income from staking or interest-bearing wallets. 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.
To hear the specific steps you should be taking to ensure you’re accurately reporting crypto transactions on your tax returns, check out our latest ZenLedger on-demand webinar here.
Bonus Question: What is DeFi?
Decentralized Finance, or DeFi, allows traders to access services like trading, borrowing, and lending without the use of a middleman (such as a Centralized Exchange, like Coinbase, Binance, or Gemini). DeFi exchanges utilize automated market-making — rather than depending on an exchange’s liquidity — by using liquidity provided by ordinary traders who pool their holdings together with other traders to create supply. By eliminating middlemen from transactions, DeFi aims to make transactions cheaper, faster, and more efficient.
Protocols like Compound, Aave, and MakerDAO allow users to lend money and earn interest. Exchanges like Uniswap and dYdX enable users to trade crypto assets without using a centralized cryptocurrency exchange. And some wallets now integrate with both, such as Coinbase Wallet and Metamask with Uniswap.
- To learn more, read: The Complete DeFi & Yield Farming Crypto Tax Guide
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 with our crypto tax software 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 daily via online chat, email, phone/text, or by appointment — we want to help you succeed in navigating these waters.
There is no doubt that there will be increased IRS enforcement on crypto taxes in 2020, but with ZenLedger and our crypto tax calculator and experienced team, we can help take away the stress and simplify the complicated bits.
Sign up for ZenLedger for free today to see how simple it is to complete your crypto taxes with our automated software!