Bitcoin Taxes

How is Bitcoin Taxed? A Guide to Navigating Cryptocurrency Taxes

Published
July 20, 2021
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    Although Bitcoin and other cryptocurrencies are often considered the Wild West of currency, the IRS has begun cracking down on taxes and fining individuals who fail to report cryptocurrency accurately. Hence, it is crucial to learn how Bitcoin is taxed to avoid any IRS penalties. 

    When it comes to US taxes, all of your cryptocurrency holdings need to be reported on your tax returns, no matter where it was acquired. All capital gains or losses need to be indicated on your tax returns. 

    But reporting your Bitcoin taxes can be complicated. So, we’ve developed this easy guide to teach you how Bitcoin is taxed, what to expect when filing your taxes every year, and how to avoid any fees or penalties from the IRS. 

    How is Bitcoin Taxed in the US? 

    Although we tend to think of Bitcoin as a form of currency, it’s considered property by the IRS when it comes to taxes. Similar to how stocks are taxed, all cryptocurrencies are viewed as capital assets under the IRS.

    In other words, Bitcoin is taxed according to changes in value for each transaction, and all capital gains and losses resulting from acquisitions. 

    Taxes are also determined based on how long an individual holds on to their cryptocurrency, with longer-term holdings receiving more favorable tax treatment. If an individual holds on to Bitcoin for longer than a year before selling for a gain, they will only have to pay capital gains taxes of 15%, but if they hold it for less than a year, they are required to pay ordinary income tax rates on all gains. 

    It’s also worth noting that if Bitcoin is bought as part of a retirement plan, such as a 401k or IRA, it will be treated like other investments: there’s no tax on gains, but the distributions are taxed as ordinary income.  

    How to Determine the Fair Market Value (FMV) of your Bitcoin

    How you receive or use Bitcoin can also impact how it is taxed. 

    If Bitcoin is mined, you will have to pay taxes on the value of the Bitcoin on the day that it was mined. The fair market value of Bitcoin can be determined by converting the value into US dollars, based on the exchange rate, which should be documented on the distributed ledger. In some cases, the transaction may not have been recorded on the distributed ledger, in which case you must use the time that it should have been recorded. 

    From there, if you choose to use Bitcoin to make other purchases, you will need to determine the market value of the Bitcoin on the day the purchase is made. The difference between the value of your Bitcoin (which would be the cost of the Bitcoin on the day it was acquired) and the market value on the day you used the Bitcoin to purchase an item will result in a gain or a loss, which will then be reported back to the IRS. 

    How to Determine the Cost Basis of Crypto? Reporting Bitcoin to the IRS

    There are a few specific instances in which your Bitcoin may not be taxed. For example, if you receive Bitcoin as a gift, or donate it to a charity, you will not be required to pay taxes on it. 

    However, if you sell or trade a Bitcoin that was gifted to you, you will need to know the original cost basis of the Bitcoin in order to calculate taxes. A breakdown:

    • If it is a gain, the cost basis is the value of the Bitcoin when the donor made the original purchase and any gift taxes that the donor may have paid. 
    • If there is a loss, the basis is the lesser value between the donor’s cost basis or the fair market value at the time you received it. 
    • If there’s absolutely no way of knowing the donor’s basis, then you can record a cost basis of zero dollars. 

    Though this may be a confusing process, it is critical to keep detailed records of each cryptocurrency transaction. Because digital currency is still so new, paying taxes on Bitcoin is not as straightforward as owning stocks. 

    For example, not all cryptocurrency platforms issue a 1099 form, which would make the process more straightforward. In these situations, it is entirely the responsibility of the currency owner to notify the IRS of any gains or losses. The way Bitcoin is taxed can be confusing, but by keeping a careful record of its value over time, you can rest assured your reports are accurate and avoid any penalties or fees from the IRS.

    FAQs

    1. How is tax calculated on Bitcoins?

    Bitcoin holders are supposed to pay a capital gains tax on Bitcoin depending on the holding period. If you’ve been holding Bitcoins for less than three years, the gains are known as short-term capital gains. This gain would be clubbed with your other taxable income and you will be taxed as per your income tax slab. On the other hand, if you hold your Bitcoin for more than three years, the gains are called long-term capital gains. In this case, you will have to pay long-term capital gains tax at 20% with the indexation benefit.

    2. Do I have to report Bitcoin to the IRS?

    No matter how you interacted with any cryptocurrencies the previous year, you must include the information on the current year’s tax return. Even those who earn an income in the form of digital currency — whether due to selling at a profit or getting paid in crypto for work performed — are supposed to report the interaction to the IRS. Failing to report your Bitcoin may have severe penalties.

    3. How do I cash out Bitcoins without paying taxes?

    The simplest way to defer taxes on Bitcoin is by purchasing the currency inside of your Individual Retirement Account (IRA). Traditional IRAs will allow you to defer tax on gains until you start to take distributions.

    ZenLedger easily calculates your crypto taxes and also finds opportunities for you to save money and trade smarter. Get started for free now or learn more about our tax professional prepared plans!

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