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 these Bitcoin tax gains and losses 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 the IRS Treats Bitcoin
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.
Despite these goals, 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.
Implications for Tax Season
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.
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.
Dealing with the Ambiguity
The IRS has made it clear that you owe taxes on any gains arising from Bitcoin transactions, but there are several instances where the guidance isn’t very clear.
For example, the Bitcoin Cash hard fork in August 2017 left many investors wondering if they owed taxes on the transaction. Since every Bitcoin holder received an equivalent amount of the new cryptocurrency for free, the free currency may be taxed the same as any other cryptocurrency transaction. Investors were then left wondering how to calculate the fair market value of a newly forked cryptocurrency given the lack of liquidity in the market.
There are also issues surrounding cost basis and foreign wallets. For instance, Bitcoin and altcoins are traded on many different exchanges around the world where there can be a significant variance in exchange rates. Without an official exchange rate, it’s unclear how to calculate the cost basis given this variability. Taxpayers may also be responsible for filing FBARs for wallets worth over $10,000 held in foreign countries.
It’s important to talk with a Certified Public Accountant (CPA) to discuss these instances if they apply to your individual situation.
Tools to Help During Tax Time
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 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.
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.